Digital Realty Trust, Inc. (DLR) Q2 2013 Earnings Report, Transcript and Summary

Good afternoon, and welcome to the Digital Realty 2013 Second Quarter Earnings Call. My name is Mary Ann, and I will be facilitating the audio portion of today's interactive broadcast. [Operator Instructions] At this time, I would like to turn the show over to Pamela Garibaldi, Investor Relations of Digital Realty. You may begin.

Thank you very much. Good morning, and good afternoon, everyone. By now, you should have received a copy of the Digital Realty earnings press release. If you have not, you can access one in the Investors section of our website at www.digitalrealty.com or you may call (415) 738-6500 to request a copy. Before we begin, I'd like to remind everyone that the management of Digital Realty may make forward-looking statements on this call. Forward-looking statements are based on current expectations, forecasts and assumptions that involve risks and uncertainties that could cause actual results to differ materially. You can identify forward-looking statements by the use of forward-looking terminology, such as believe, expects, may, will, should, pro forma or similar words and phrases, and by discussions of strategies, plans, intentions, future events or trends or discussions that do not relate solely to historical matters. Such forward-looking statements include statements related to rents to be received in future periods, lease terms, rental rates, leasing and development plans, supply-and-demand drivers, data center sector growth, strategic initiatives, acquisitions and investment plans, returns, cap rates, capital markets and finance plans, including our funding strategy, our global revolving credit facility and term loan, debt maturities, capacity and covenant compliance and the company's financial growth, financial resources and success, our connectivity initiative and deployment plans and the company's future financial and other results, including the company's 2013 guidance and underlying assumptions. For a further discussion of the risks and uncertainties related to our business, please see the company's annual report on Form 10-K for the year ended December 31, 2012, and subsequent filings with the SEC, including the company's quarterly reports on Form 10-Q. The company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise. Additionally, this call will contain non-GAAP financial information, including funds from operation or FFO, adjusted funds from operation or AFFO, core FFO, earnings before interest, depreciation, taxes and amortization or EBITDA, adjusted EBITDA, net operating income or NOI and cash NOI. Digital Realty is providing this information as a supplement to information prepared in accordance with GAAP. Explanation of such non-GAAP items in reconciliations to net income are contained in the company's supplemental operating and financial data package for the second quarter of 2013 furnished to the SEC and available on the company's website at www.digitalrealty.com. Now I'd like to introduce Mike Foust, CEO; and Bill Stein, CFO and Chief Investment Officer. Following management's remarks, we will open the call to your questions. [Operator Instructions] I will now turn the call over to Mike.

Thank you Pamela, and welcome to the call, everyone. I will begin today's call with a brief summary of our second quarter operations. After my comments, Bill will discuss our second quarter financial results, capital markets activities and the revised 2013 guidance. Following his remarks, we will open the call to questions. We continue to experience strong leasing momentum and demand across our portfolio, particularly with our traditional customer base. That base consists of large corporate enterprise users, cloud infrastructure providers and Internet-based applications and services, including e-retail. They rely on Digital Realty to provide a dependable and secure environment for storage and processing of mission-critical electronic information, as well as housing primary IT applications. These corporate enterprise customers, representing leading companies from financial services, consumer and health care sectors, among others, often require large, multisite builds that deliver high-quality, long-term revenue for Digital Realty. Looking forward, we're implementing several strategic initiatives that will make our best-in-class data center platform more accessible to a wide range of enterprise customers and IT service providers. One such initiative is the transition of our sales team from one highly focused on opportunity management to a more diversified approach and raising [ph] a heightened focus on strategic account management under the leadership of Matt Miszewski, our Senior Vice President of Sales. This transition will match our market segmentation to our strategic sales effort and is designed to result in higher average deal sizes, shorter deal cycles and increased pricing power. We've also been working to implement a diversification revenue enhancement strategy by targeting mid-market customer segments within specific verticals selected for their growth potential. These targets will include companies that meet Digital's ideal customer profiles and as such, represent latent market demand and are positioned within verticals that represent higher probabilities of closure for…

Thank you, Mike. Good morning, and good afternoon, everyone. I will begin by discussing changes to our accounting policies, as well as new disclosures in our quarterly supplementary report. I will then review our quarterly results, provide an update on our funding strategy and capital markets activities and address our revised guidance. In terms of our accounting policies, to be more in line with GAAP accounting practices, in the second quarter, we began capitalizing all eligible portfolio-related costs totaling $10,000 or less, including those incurred in the first quarter. Previously, these costs were being expensed. In addition, we conformed [ph] our policy covering construction period offering cost with our interest capitalization policy, such that completion dates are now consistent. Our effective completion date is tied to receipt of certificate of occupancy. As a result, in the second quarter, we capitalized $3.4 million of additional operating repairs and maintenance and real estate tax expenses, of which, $1.5 million relates to the first quarter. Separately, in response to requests from our shareholders, we have made additions and clarifications to our quarterly supplemental report. This includes a new schedule on Page 26, titled Portfolio Overview by Property Type. This schedule provides further visibility into our portfolio by consolidating our properties by corporate data center, Internet gateway, data center and nondata center properties. Within each property type, we have also provided detailed information around the annualized base rent by product type. In addition, on our historical capital expenditures schedule on Page 29, we have modified the footnotes to improve the definitions of how we categorize recurring and nonrecurring capital expenditures. These modifications have been made to further clarify how we define capital expenditures. On Page 10 of the supplemental, capitalizing internal leasing commissions are now separately disclosed on the AFFO reconciliation. Recurring capital expenditures…

[Operator Instructions] Your first question comes from the line of Emmanuel Korchman of Citi.

It's Michael Bilerman here with Manny. Bill, I just wanted to just dive into the accounting things just for a moment. So you didn't restate first quarter results at all from FFO, you just adjusted FFO for the CapEx disclosure. But I'm more concerned about sort of earnings. So this $3.4 million change is effectively that $0.025 all in the second quarter?

That's right. So roughly $0.01 of that would have been in the first quarter.

Your next question comes from the line of Gabe Hilmoe of UBS.

Bill, just a question on the joint venture. I guess, can you talk a little bit about potential size, who the -- what kind of partner might that be? And is this, in terms of the deal, like one large deal? Or is this kind of a staggered transaction that could close over a period of time?

I'm reluctant to go into too much specificity before we close. But I will tell you it is one deal. Approximate deal size, we'll say, between $350 million and $400 million. It's one institutional investor. It's, I believe, a highly regarded institutional investor in the real estate space. And right now, we're expecting just -- I think I said one close, and that will -- I expect that will be in the third quarter.

Your next question comes from the line of Rob Stevenson of Macquarie.

Can you talk a little bit about the Asia-Pacific business as to what you're seeing there in terms of opportunities to both expand and from a leasing standpoint?

Sure. I'd be happy to. So we're seeing new opportunities in Japan. We expect to be closing soon on a development site outside of Osaka. We're moving ahead on schedule with our new development and joint venture with Savvis in Hong Kong and have very good interest in that new development. Also continue to discuss potential joint ventures with IT services companies in China, we'll see where that goes. And then we're seeing a pickup in leasing now in Singapore. It was a little slow for a couple of quarters, and now we're seeing requirements pick up in that market, which we know is going to be a very strong market ongoing for. So Asia, we see as having really good opportunities. And we have good activity in Sydney and Melbourne on those developments as well. You may recall, in Melbourne, NAB is the anchor tenant there and we have a couple of international firms as our anchor tenants in Sydney.

Your next question comes from the line of Jonathan Atkin of RBC Capital Markets.

Yes. So I was interested in what you're seeing in terms of competitive behavior. You talked a little bit about supply being scarce in a number of markets, the competitive behavior, and when deals go away from you, what's the most common reason? And then maybe just an update on the connectivity strategy. You mentioned where you hoped to be by yearend. But if you could elaborate on your ability to fully pursue that business in the U.S., given some of the exclusivity that Telx has to offer the interconnects within several of your sites.

Sure. We have certainly a very large footprint in North America and globally, which allow us to provide a wide range of space both in our Internet gateway buildings, as well as in our suburban data center facilities. So we can provide that space, whether it's smaller colo space or larger wholesale space, over a megawatt, to these different corporates and IT services companies that are delivering cloud services and require that connectivity. So all in all, I think we're incredibly well-positioned to deliver the space and the connectivity within our buildings, within our business parks. And as we mentioned back to the major network and Internet peering points, whether they're at in an Equinix facility or driving more business as well to an Equinix or Savvis or other folks. So it generally should be a win-win because hopefully we'll be driving more connectivity and Internet traffic back to these various peering points, whether they're in a Digital building or in another location. I'm sorry, the other question. Sorry, when we're seeing competitors -- competitor pricing. Typically, when a deal is done away with us, it's usually on price, where in some cases, we just feel we won't go as low as some of the competitors might, especially some of these folks that have 1 or 2 sites and don't have a portfolio approach to their business necessarily. But oftentimes, we are able to achieve a premium over our competitors because of our service, our professional operational platform and the fact that we can -- because of our modular POD architecture approach, we can customize spaces even within our Turn-Key Flex designs to meet the application requirements of the IT department. And that's very powerful as well as having fully dedicated UPS and cooling to the suites. And having that dedicated backup power and cooling is a very important criteria, especially among the corporate enterprise financial services groups.

Your next question comes from the line of Jordan Sadler, KeyBanc Capital Markets.

A couple of questions. One question, 2 parts. So on the potential joint venture, the size was helpful. Should we expect pricing to be the range, Mike, that you offered up that you're seeing pricing in the private market, high 5s and mid-6s? And separately, as it relates to the guidance adjustment, what portion in total related to the accounting change? I think you said it was $3.5 million or $3.4 million of additional OpEx for the first half. So is it appropriate to annualize that, get to $7 million for the full year essentially of additional capitalized OpEx?

Yes. Roughly $0.05 for the year from that, Jordan.

$0.05 benefit?

Roughly. Yes, I'd qualify [ph] that. And then in terms of the JV again, we're in negotiations with a partner now. So I'm reluctant to say too much. You can assume the cap rates are -- they'll be in rates that are attractive to us.

Yes. I mean, they'll be significantly below our guidance for new acquisitions because of the long-term leases and stability in those assets.

Your next question comes from the line of Jonathan Schildkraut of Evercore.

Thanks for giving us the extra color on the leases that occurred in July. I was wondering if you might give us a little background there and maybe we can get a sense as to whether it was Turn-Key or Powered Base Building and if the rates were sort of in line with what you saw in the second quarter.

Sure. Yes, it's a -- the leases were almost entirely Turn-Key Flex or fully fitted-out Custom Solutions that we'll be building. And in colo space, that's fully fitted-out colo space. And that's consistent with the trends we're seeing now. We are doing a few Powered Base Building leases but well over 90%. I think of the deals we're doing now are Turn-Key. And rates being pretty consistent with what we've been doing historically, probably be a little higher in that case. So a nice combination of existing customers, new customers and seeing a lot of expansion in multiple sites, as we mentioned around trends with big data and cloud and hybrid cloud.

Your next question comes from the line of Vance Edelson of Morgan Stanley.

Just another question on July. Could you quantify how much of July's strong leasing, in other words, how much of that $19.5 million in rental revenue signed would you characterize as having been delayed from the second quarter versus what might just be ordinary July signings, so to speak? I'm just trying to get a feel for whether there's any acceleration in leasing in July versus what the monthly average throughout the second quarter was.

Yes. Actually the great, great majority of what we achieved in the last 3 weeks were leases we expected to close by June 30 and spilled over. There might be a couple million dollars of revenue, $1.5 million to a couple million that we would consider third quarter deals. And we expect to third quarter to meet our expectations in terms of leasing velocity. So we're very comfortable that we're on track. It's hard to keep in the course of business to keep too specific dates and quarter-by-quarter. And so it's -- as you all can appreciate it, it's often better to view things on longer timeframes. But yes, the leasing velocity is very good, we think.

Your next question comes from the line of John Stewart, Green Street Advisors.

Bill, just a couple additional follow-ups on the JV. First of all, the $350 million to $400 million amount that you referenced, is that the transaction size or is that proceeds? And are you talking about closer to the sale of a 50% interest or an 80% interest? And last but not least, have you seen any sensitivity from your partner on pricing, given the recent move in rates?

So the $350 million is the total asset value. We are looking at 20-80 joint venture, where we'd be 20% and our partner would contribute 80%. So 80% of that $350 million to $400 million will be coming back to us. And we've seen no sensitivity as a result of those changing rates.

Your next question comes from the line of Tayo Okusanya of Jefferies.

I'm trying to get my hands around the outlook for lease commencements. You've done about $53 million year-to-date. You have about another $43 million of leases signed but haven't commenced. Just kind of thinking about the back half of the year and where you were last year, you had $135 million, how comfortable you feel with the ability to kind of do better than that this year, given your outlook for the back half.

We're certainly on track -- probably maybe even -- we're certainly on track to meet our budgets and our revenue expectations. We're probably lagging a little bit from a timing perspective, especially with these leases that are falling over by 3 or 4 weeks, do have an impact in terms of timing. But I mean, we're confident we'll be in our guidance range.

Your next question comes from the line of George Auerbach of ISI Group.

Mike, you mentioned that the leasing in the second quarter was consistent with kind of the new expectations for the year. I guess, can you just update us on the -- your sort of targets for leasing commenced space here in the 2013 and how that relates to what you achieved in 2012?

We're certainly, on the lease signings, we're well ahead of where we were at this point in time in July of 2012. I don't know off the top of my head how far ahead we are in terms of lease signings.

Roughly $80 million into mid-July equates to, I think, the first 3 quarters of last year for signings.

So on signings, we're...

2.5 months ahead.

Right. So we're making very good progress on signings. As I said, the commencements have been delayed a little bit from our expectations, especially with the latest batch of signings in July, which is great. But they're a few weeks later than we anticipated. So that will have a bit of an effect on the higher end of commencements.

Your next question comes from the line of Vincent Chao of Deutsche Bank.

Just curious on the comments about the sales force initiatives. You mentioned one of the benefits being hopefully getting some shorter leasing cycles there. I'm just curious, are you -- and just in relation to the comments about the commencements, but are you seeing any shortening in the leasing cycle today just as a result of changing business conditions or improving business conditions?

Not with our larger enterprise customers, and for a variety reasons there. These are large deployments for them and in large internal budgets for their own IT deployment and their own costs over and above the data center we're providing. As you can imagine, there's more levels of approval now, even for budgeted items within most organizations of substance that we're dealing with. And we're doing more customization as well. With our Turn-Key Flex product, we're doing a lot of tailoring to the IT application requirements themselves and customers' operating program. So that's taking some additional time as we go through the design and engineering project with our -- process with our customers for our Turn-Key Flex POD approach.

Your next question comes from the line of Bill Crow of Raymond James & Associates. William A. Crow - Raymond James & Associates, Inc., Research Division: Two questions. Bill, any interest in using proceeds from the joint venture to buy back stock at the current price? And then the second question -- well, let's just leave it there with that question.

Bill, that's one of the alternatives, for sure. So when we close the venture, we'll have to look at what our investment opportunities are at the company. And depending upon investment opportunities, we would either use all the proceeds to pay down the revolver or the other alternative would be to make the use of proceeds leverage-neutral, which is to say partially to retire debt and partially to retire equity in accordance with our pro forma capitalization. And of course, we could do anything along that spectrum.

Your next question comes from the line of Jamie Feldman of Bank of America. There is no response from that line. Your next question comes from the line of Emmanuel Korchman, Citi.

Yes, it's Michael Bilerman again. Bill, I was wondering maybe you can just explain a little bit more sort of what exactly, when you went through the maintenance and the change in capitalization policy: a, just really what the driver of the change was; two, I guess, why you felt that, that wasn't really material of putting that in the press release and the supplemental as sort of forewarning people beforehand just given how much scrutiny CapEx overall has received and the materiality of that being $0.05. And then lastly, from an FX perspective, I guess, I'm surprised at the magnitude. I know the U.S. dollar has strengthened a lot. But just given the fact that you have local debt in a lot of these markets helping to offset some of the impact, I guess, I'm surprised at the magnitude of you really saying in FX is a $0.05 hit.

I'll start with the FX, Michael. I think there must have been a misinterpretation there. So the FX is, I think, probably $0.01 hit at most, maybe $0.02. In terms of the -- what was the question on the -- oh, capitalization. So a little additional clarification on the capitalization. So we had -- and previously, we had been expensing all capital expenditures of $10,000 or less. And today, we are capitalizing what's appropriate to capitalize down to any amount, which is really consistent with GAAP. The $10,000 and lower policy, I think, was more or less a holdover from our IPO days. $10,000 was a holdover from our IPO days when we had limited resources and there was a question of our ability to track, from a capitalization standpoint, expenditures of $10,000 or less. And we just -- honestly, we didn't consider $0.01 in the first quarter to be particularly material.

That's really to bring ourselves in line with GAAP and what we see as the capitalization policies of most of our peers and other companies. But we're still being fairly conservative.

Yes. I mean, the other change on operating expenses, we were -- we started to expense operating expenses, recognize expenses prior to the cessation of the capitalization of interest, which is obviously not consistent. So now the operating expenses and the capitalization of interest line up. And the split between those 2 was roughly 50-50 in terms of effect.

Your next question comes from the line of Dave Rodgers of Robert W. Baird. David B. Rodgers - Robert W. Baird & Co. Incorporated, Research Division: So Mike, in your prepared comments, I know you talked about delayed leasing commencements over the course of between now and, I think, through 2018. You don't have to go through those again, but maybe if you could break them down between stabilized assets, what's under construction and what needs to be started from a development perspective to deliver on those leases.

Yes. Well, generally, I wasn't speaking anything beyond 2013. So I wasn't projecting out beyond this year. So I do want to make that clear. And really the timing is not around so much around construction in most markets. It's because we're continuing to deliver data center inventory where we need it, both Powered Base Building and Turn-Key, and we can build a Powered Base Building very rapidly. So it's really the timing, which I wouldn't say timing is longer, but we're still seeing pretty elongated discussions and planning with our larger customers. And that's one of the reasons why we also want to focus, in addition, on middle-market customers, where we might be able to move more rapidly and smooth out the lumpiness of our signings and commencements. And the other thing, these transactions just don't follow hard-and-fast quarter-by-quarter rules. They take the amount of time that the customer needs. So they're not really focused on quarterly completions themselves. So you'll get these different deals extending as long as we need to make sure that the customer is getting the right solution.

Your next question comes from the line of Steve Sakwa, ISI Group.

I guess, I just want to clarify, Bill. So it sounds like you're having better leasing signings, but the commencements are a bit delayed. So the fact that guidance went up, I just want to be clear, that's really all due to the capitalization policy change and not due to faster leasing? And then secondly, you mentioned that tenants were taking space in some of the outyears, but I was surprised that tenants were committing to space to '16, '17 and '18. And I'm just trying to understand the thought process behind, I guess, the tenant committing to space effectively 5 years out and your committing to space 5 years out.

So the answer to the second question, Steve, is that we have a build-to-suit one deal that has some long pickups, if you will, where we're delivering space in the outyears.

And very big.

Yes, it's a very large deal. And answer to the first question is yes. The -- about a $0.05. There's $0.05 in the forecast that's related to the change in accounting policy. And commencements, as Mike said, have been delayed, which affects revenue recognition and acquisition. And that would drive the guidance.

Your next question comes from the line of Jonathan Schildkraut of Evercore.

Yes. Just a follow-up on the offsets. Were there any other offsets to the capitalization change, policy change other than the FX?

I mean, there are ins and outs, Jonathan, that we would expect to -- the G&A might come in a little bit lower. OpEx might come in a little bit lower. But it's no more than $0.01 or $0.02 around the edges.

And I think looking at our overall guidance and projections, on the high end, we think we have an opportunity to achieve additional leasing, as well as additional operational efficiencies. So we're now looking entirely at capitalization policy as driving what we think could be our higher end of our range.

Your next question comes from the line of Tayo Okusanya of Jefferies.

Yes. Just one quick follow-up around development. The guidance is for $980 million of development deliveries. From the supplemental, you can get a sense of, you've done about 400 square feet of deliveries year-to-date. But we don't really have a dollar value behind that. Could you give us a sense of how much dollar-wise you've delivered and how much is still to go and where that additional development deliveries meant to come from the CIP [ph] pipeline?

I don't know if we have the dollar amount available.

We'd have to get back to you on that.

Yes. I mean, we have how much we spent. But you can see on Page 30 of the supplemental, the construction in progress by market breaks down the relative amount of activity in the different markets.

Yes. But which of these pieces are delivering in 2013 as part of your overall guidance?

I think, overall, we're delivering about a total of them of 1 million square feet, a little more than that.

A lot of the capital deliveries is back end-weighted in the year, Tayo. That's when the project completions are.

And when we're building out the Turn-Key components.

That does conclude the allotted time for our Q&A session for today. I would like to turn the call back over to the speakers for closing remarks.

Thank you for your time, everyone, and your attention to the company, much appreciated. And I want to congratulate everybody here on the Digital team for a terrific effort and on continuing to deliver a high level of service for our customers and very good, consistent earnings for our shareholders. Thank you very much, everybody.

Thank you for participating in today's conference. You may now disconnect.