Well, good morning. For those of you, web streaming, welcome back to Citi's 2023 Communications, Media and Entertainment Conference. For those of you I haven't met, I'm Mike Rollins, and I cover communication services and infrastructure categories within Citi Research. Before we get started, I'd like to mention that we do have disclosures available at the registration desk and on the Citi Velocity page from which you're streaming the audio. We're gonna work to incorporate your questions into today's discussion. If you're in the room, you can light up the microphone and we'll get to your question. If you're online, you can submit your question into the box. We're gonna continue the tradition of using live surveys. They're completely anonymous.
They can be accessed on the live polling Q&A section of the streaming site, as well as using your connected devices here in the room. With all that out of the way, I'd like to welcome Matt Mercier, newly appointed Chief Financial Officer of Digital Realty; and Jordan Sadler, SVP, Public and Private Investor Relations of Digital Realty. Thank you both for joining us today.
Yeah. Thank you, Michael. Appreciate being here.
Thanks for having us.
Well, congratulations on the new role.
Thank you. Thank you.
You know, we're curious for you to share your first acts now, as, you know, and priorities for CFO of Digital Realty and even just more broadly, you know, how you're thinking about those priorities for the company, maybe differently than what, you know, we would've been talking about a year ago.
Sure. Well, you know, I've had the benefit of being around Digital Realty for a good part of the, you know, the time we've been public, being behind two great CFOs, Bill Stein and Andy Power. Have had the pleasure of being part of, you know, the journey we've been on over the last, you know, not only my 15 years, but in particular over the last, you know, call it three to five, as part of building out the strategy and repositioning the company to where it is today. You know, I don't foresee any major shift in the strategy that we're embarking on.
You know, if you go back, just even a couple years, I think, Michael, as you know, we've been embarking on a strategy which is, you know, encompassed by kind of the three key terms that we like to talk about, which is being global, being connected, being sustainable. You know, in terms of global, as I think hopefully most people know, we've been on that pursuit with, and made, I think, great progress in terms of where our portfolio is today. I think it'd be hard-pressed to find somebody who would tell you that our portfolio isn't stronger than it was, you know, two years ago and three years ago and five years ago, between our combination with Interxion back in 2020. Most recently, getting a majority stake in Teraco.
So we've been, you know, other acquisitions in between there that have been, you know, call it more, networks, network-centric, you know, enterprise-oriented, with, you know, in places like Greece and Croatia. I think you're gonna, you know, we will continue to embark on, you know, being part of the cloud service providers, you know, one of their preferred vendors and partners going forward, as well as continuing to call it attack and gain share within the enterprise colocation segment as part of that, as part of our ongoing strategy going forward.
you know, at the same time, I think what we're, you know, what we'll emphasize even more is, you know, I think at this, at this point, we've, you know, in terms of global, I think we've, you know, not fully checked the box, but I think it's a pretty good check the box in terms of where our portfolio sits today globally. You know, we have 300 data centers across, you know, 50+ markets, 26 countries.
You know, I think our view and belief is we're in the majority of the major markets you wanna be in to be a global player and to be able to deliver the capabilities and the deployments that our customers are looking for across both segments, both the hyperscale cloud service providers as well as the enterprise. I think now then we're looking, we've got the breadth of our portfolio. Now we wanna call it go into the depth in terms of, you know, creating and optimizing what we do have, you know, messaging and further creating a more powerful value differentiator for customers in particular within the enterprise segment through our connectivity offerings.
You know, we launched Service Fabric last year, you know, continuing again to make, you know, overall make it easier for those customers to do business with us as well as connect with others across the globe. All that, I think, comes back to, you know, one of our, you know, one of our key goals, I think for going forward, which is, you know, all the, all the work that we've done is really accumulating in positioning our portfolio for sustainable organic growth. That's really what we're targeting to deliver. You know, I think we've started to see that over the last year with improved pricing, re-leasing of vacant capacity.
We think with where the environment is today, you're gonna continue to see continued strength within our organic growth as that becomes a focus of ours, or has been a focus of ours. I think you'll, you know, we're positive about where those trends are going. I would say second, you know, we'll, you know, we're also priority is to, you know, restore, call it restore the balance sheet and bring that to where, you know, where it was over time.
That's really helpful and gives us a lot of topics to drill down into. We'll introduce our first survey question and see what our audience thinks. You know, one question that we've asked before, we're gonna ask again is, does Digital Realty need to acquire additional assets to strengthen or expand the global strategy? You were just talking about that a little bit. Curious what our audience thinks. You know, the choices are gonna be yes, expect Digital to add new markets through acquisitions of additional platforms. Yes, expect Digital Realty to further consolidate retail centric data centers and campuses. No, Digital Realty has the geographic footprint it needs and can expand through organic development. Just a reminder, these are completely anonymous, and so we'll aggregate those results.
While we do, maybe you could just talk about a little bit more since the first time we've been together, since there were some transitions, you know, both for Andy and for you. Can you just unpack a little bit of just, you know, maybe what led to the unexpected timing and process for the management transition? Were there any performance issues for the company in the fourth quarter of 2022 or unexpected developments for 2023 that investors should be mindful of?
I mean, just to hit the maybe your last part straight. I mean, there's no performance issues or unexpected developments that led to this. I mean, this was, you know, understandable in terms of like the maybe the abruptness of the timing between announce and actual final day. If you look back, the overall transition plan has been in place for well over a year. You know, Andy was appointed president back in November of last year. With that came additional responsibilities that, you know, you would say signaled kind of where, you know, the path that we were on. You know, behind the scenes was which may, you know, wasn't as visible.
Myself, I've had a lot of the financial operations of the company for not only that period of time, but you know, in some cases, even further beyond that in terms of, you know, running, you know, running the finance at PNA Group, capital markets, accounting. I've been, you know, in the same boat in terms of transitioning for this point in time. You know, this was a planned succession plan. You know, understand that the, you know, my view would be abruptness in terms of timing, but this was something that was put in motion some time ago.
That's helpful. you know, just to share the results of the first survey. 14% of our audience expects Digital Realty to continue to add new markets through acquisitions of additional platforms. 29% you know, consolidate retail data centers and campuses. 57% that you have the geographic footprint that you need and can expand through organic development. you know, as you think about these choices, do you fall into, you know, one specific bucket over another?
I mean, I think the, you know, as usually happens, the majority tends to be right. I think, you know, like I said before, I think we, you know, looking across where we've been and where we, you know, where we've come from a global perspective, you know, reiterating we're in, you know, 300 data centers across 50 markets. You know, at this point in time, I think we believe, you know, that we're in most of the major markets that we need to be in. You know, that said, are there markets over time that we'll look to expand into? You know, that's obviously not off the table 'cause we wanna be where our customers wanna be, and that evolves over time.
I think as of now, we're, you know, we're in most of the major places we wanna be, at this time.
We're just talking about the asset positioning. Can you unpack a little bit of where the sales organization, the support organization sit? Are those in a good place to execute the sales strategy going forward?
Yeah. I mean, I would say with, you know, looking at it in kind of our two buckets, right? The cloud service provider, hyperscale component, you know, that's a finite limited group of customers that doesn't take a large sales force to be able to attack. You know, that also continues to be a good majority of the business that we're signing, you know, anywhere between, call it roughly 60%, whereas the other 40%-ish, depending on the quarter, comes from our, you know, enterprise, more retail colocation.
You know, and we've been, you know, while we're looking to grow that enterprise footprint, you know, we also have to make sure that we've got the inventory in place to be able to sell it before, you know, bringing on excess headcount, you know, that won't have the right capacity to sell. I think as of today, given where we're at and where our inventory profile is, I think we feel pretty good about the sales organization and where it is. You know, we're obviously continuing to look at bolstering our channel partners and having that sales force multiplier. Overall, I think we feel pretty good about the sales organization and where it is.
You know, as we continue to grow and look to penetrate further than enterprise, then we'll reevaluate that.
I would just maybe add to that or point out that, over the course of the last four quarters, three of them were record quarters in terms of lease production. I think the sales force is sort of adequate, and it's been pretty mixed across product type too. I think we feel pretty good about that. It's, I think as Matt said, it's an opportunity as we sort of scale and look to go into different product areas and markets, but no sea change.
I'm glad you brought the bookings up because that takes us right into the second survey of our time together. We're gonna ask our audience, how will average quarterly bookings in 2023 compare to what I recall the last eight quarter average being around $136 million? We're just gonna simply ask, you know, is the quarterly bookings in 2023 gonna be higher than that average, similar, or lower than that average? We'll go to the polls, you know, in a moment.
While we're doing that, you know, and this might, you know, help inform some of our audience on what the right answer should be, you know, Jordan, to what you were saying, maybe, if you could share a little bit more of what you're seeing in the sales funnel, sales cycle. I recall back on the third quarter, you noted that maybe some smaller customers were seeing some weakness, you know, in, within the channel. If you can give us an update on what you're seeing on that front.
Yeah.
Yeah, go for it, Matt.
Yeah. you know, overall, you know, we feel pretty good about the demand profile. I mean, as Jordan mentioned, we've, you know, the last, you know, year to date, we're, I think, close to $450 million in total bookings. We've had two record quarters this year. you know, as I think as we've all experienced, this has been a volatile year in terms of macro changes, you know, and as a result of that, on the third quarter, you know, we thought it was prudent to mention, you know, a sliver where we are seeing some softness. I think overall that softness is, you know, we're not seeing it get, you know, any worse.
In fact, I think it'll be, you know, staying through improving potentially within, again, a small segment of our call it 0 MW- 1 MW that we're attacking. You know, within hyperscale, we continue to see a lot of demand. In some cases, I think more demand in certain markets than their supply. Overall, we feel pretty good about the demand profile, the pipeline and what we're seeing in terms of what we have available.
I might just add to that, just to come back to the small medium enterprise comment that we made on the third quarter call. This was, you know, a decision to basically be transparent with the investor and the analyst community and say, you know, "Are you guys seeing anything? The capital markets are falling apart. Interest rates are up dramatically. Are you seeing anything macro that you would identify or call out?" 'Cause we were already obviously well into October, that you could say, you know, "Hey, there's something going on in your business. How are all of your customers behaving?" We obviously have, you know, well over 4,000 customers. We did see something, so we said something.
What we saw was in this smaller medium enterprise segment of our business, which is for us a smaller piece of the business, right? It fits into the 0 MW- 1 MW business as opposed to the greater than one, obviously. Within the 0 MW- 1 MW , you know, we sort of sub-segment into 0 kW- 500 kW and 500 kW up to a meg. It was at 0 kW- 500 kW where we saw, you know, a hesitancy from CFOs and CTOs to make that capital commitment as the quarter came to an end. It was an anecdotal comment. We wanted to make sure that we flagged that anecdote for folks.
Mm-hmm.
Much of that pushed into the fourth quarter pipeline. There was a hesitation. You know, we think, you know, an execution behind that. You know, people have to assess, you know, based on current conditions, what are we gonna do? I think, you know, some people will not wanna spend their own capital. They'll look to lean on partners, maybe go to the cloud or bare metal. Others will commit and execute 'cause they need the product.
From the survey, I'll read out the results. About 40% was similar and about 60% was lower in terms of the quarterly bookings opportunity for 2023 versus 2022. You know, given what you're describing about the demand for hyperscale and, you know, what you're describing on the portfolio broadly, how would you vote in the survey?
Yeah. Well, I'll give some context, right? I mean, you know, look, what we're seeing is we're seeing solid demand. We've seen that in, you know, like we mentioned, record quarters, two of which happened this year. We're coming off a solid year of performance. You know, on top of that, we're also seeing that there are supply constraints in certain markets, one of which being the, you know, largest market in the world in Northern Virginia, as a result of power constraints.
If you think about, you know, just those two, you know, kind of anecdotes in terms of, you know, hard to keep putting up record after record as well as, you know, supply constraints in certain markets, you know, I think that'll kind of give you an indication of where, you know, where things might be heading.
In terms of, kind of gets to next topic. You know, you mentioned, you know, some energy constraints, and there's just higher energy costs, you know, overall, in certain of your markets right now. Are you seeing any customer resistance or pushback or change in demand because their total cost of operating in a data center may be higher than it was a year or two years ago?
No. I mean, we haven't. I mean, you know, I think this has been telegraphed for some time, right? People are aware of the increase in power costs. You know, for the customers that we're targeting, you know, these aren't decisions where, you know, they can, you know, have data center deployment or not. These are mission critical to their business. As a result, you know, they're maybe not happy about where power costs are, just like probably most of us aren't. These are necessarily deployments that they can't necessarily delay. We have not seen any material change as a result of pricing, power pricing increases within any of the major markets that we're operating.
On the other side of this, with some supply constraints and an inflationary backdrop, can you give us an update on how Digital is approaching pricing and what kind of opportunity that is for the organic financial performance of Digital Realty?
Yeah. Yeah. I mean, we've, you know, look, I think, I think hopefully, as I said in the beginning, I think we feel pretty positive about where the trajectory of pricing is going, and that's across most of our major markets. I think that's been reflected in the fact that the, you know, this year, I think the first time in several years, we guided to positive renewal spreads. You know, we're hopeful and optimistic that that continues. You know, part of it is, again, an offset to some degree of limited supplies that, you know, pricing, you know, could and should go up along with that. We are seeing that in a number of our markets.
You know, in addition, we're, you know, we're looking to include, you know, further escalators in where we are pricing even, you know, to not only be a reflection of the pricing environment, but also some version of the inflationary environment. I think as we announced on last quarter call, we've got, we were able to get, you know, roughly 40% of our contracts with CPI inflation, which is an adjustment to, you know, what we typically have, which is call it anywhere between 2% and 3% fixed, you know, on average. We feel pretty good about where pricing is trending. We think pricing power has shifted towards the owner operator's hands.
And we think that then, also back to, you know, kind of some of the opening remarks should then be reflective of an improvement in overall organic growth.
That brings us to our next survey question for our audience. Will the potential improvements in pricing push stabilized KPIs for revenue and NOI back to meaningfully positive territory in 2023? This is a simple no or yes answer. We'll go to the polls in a moment. But, you know, as you're thinking about these price increases and the opportunities for these inflation-based escalators, and this might help inform, you know, our clients on what the right answer should be here. But do you kind of view this as zero calorie revenue, where it's just offsetting inflationary pressures in the business? Or do you view this as an opportunity to get better value and returns out of your portfolio?
Look, I think ultimately we view and our objective is to get, you know, to increase the overall bottom line, you know, from pricing, especially from an organic portfolio called stabilized same store perspective. You know, we're also not immune to inflationary pressures within the operating expenses. You know, outside of power, which we talked about, which for our business is largely a pass through. You know, the operating expenses that make up the majority of it underneath that are, I think we've been able to control very well. Therefore, as we look to our revenue growth from an organic perspective, you know, we think that we'll see not only improvement at the top line, but then therefore should flow down to the bottom line as well.
If you take the power pricing out of this question for a moment, and you look at the core margin performance, you look at what you're doing with these connected services and these ecosystems that you're building for customers and, you know, broadening the sales opportunities. As you look at the cost structure, should investors expect Digital to be a net investor? You know, take a little drop in margin to drive more top line neutral to margin? Do you have the scale and you have the people you need, where now you can actually get that operating leverage and expand margins?
Yeah. Again, you know, I think the main point is excluding power, because depending-
Yes.
On how you look at it, that's, you know, we are expecting an increase in overall power costs and therefore reimbursements, which depending on how you're looking at margin, would have an impact. Excluding margin, you know, our view is, you know, again, going back to our objectives, we, you know, we're looking to increase our occupancy, so bring in which we've been embarking on over the last year with move-in ready initiatives. I think you've started to see that even in the last quarter where you saw our stabilized portfolio and our overall portfolio increase in occupancy. I think that's one of the, probably one of the bigger drivers of getting better margin improvement is just filling some of the, you know, vacant capacity that we've had, which we've done a good job of doing.
Then add on top of that, you know, better mark to market opportunities, which we think we'll see going forward. I think overall, we're looking at an organic growth profile where we should be able to, you know, I'll say, maintain, if not move in the direction of improving our margin excluding energy. To answer your question directly on back to do we think we have the investments that we need? Most I think, you know, for the next year, I think we do. I think after that, you know, we'll continue to evaluate year by year, depending on the profile of the market, the profile of our inventory and our objectives and make decisions from there.
Coming back to the question about the KPIs for revenue and NOI to get back to meaningfully positive territory. Now I'll kind of look, you know, I should include in the question, but I think of it as a constant currency basis, you know.
Mm.
Take that out of the mix. it was, you know, a mixed response, 60% no, 40% yes. curious, you know, how you're looking at the opportunities to get these KPIs back to meaningfully positive territory, constant currency. Are there any potholes in the road as you're looking out at the highway that we should just be mindful of, you know, one-timers or special situations and things of that nature?
You know, I think, you know, I'm hopeful people look at. I think we've already started to see some, you know, some reversal, if you will, or, and reversal meaning, you know, we have started moving in a positive trajectory in terms of our stabilized organic growth, both from the top and bottom line. I think, you know, based on all the factors that we just discussed, meaning looking to improve occupancy, looking at a better pricing environment overall, I think we're pretty positive that we'll be able to show continued improvement in those metrics.
Obviously, we'll come out with guidance on that, towards the, you know, on our fourth quarter earnings call, which will be in call it mid-February. I think that'll, you know, we'll be able to discuss it even further then. In terms of, in terms of, you know, headwinds from that organic, you know, I think we talked about it, most of that as well. From, you know, a power perspective, you know, we feel very insulated. You know, we've had hedging programs. The majority of our contracts are pass through. The ones that aren't pass through, we have the ability within the contract to adjust the pricing as a result of increases in power.
That gives us, you know, a lot of comfort from one of the big areas of expected increase, which is on the power side. From other operating costs, you know, I think we've done a great job of, you know, with our scale and with our vendors being able to control increases in operating expenses. I'm not, I'm not aware of as of today any, you know, major wild cards. You know, property tax is always something that comes up here and there. You know, again, as of this point, nothing has come to light that gives us any concern on that front.
You know, we feel pretty good about where we stand as of today, in being able to deliver, you know, a positive, you know, positive message around our stabilized organic growth.
Maybe moving over to the balance sheet for a few minutes. You talked about that earlier in our conversation about, you know, the focus on balance sheet. Can you walk us through where you are effectively, you know, leverage today, where you would like to get that to, and the journey of what investors should expect to get to that level?
Sure. Yeah. I mean, you know, you know, the, you know, our leverage is, I would say, higher than, you know, than it's been in the past. You know, and we are, as I think mentioned in the opening remarks, you know, one of our objectives is to, you know, get the balance sheet, restore that back to where we have been. Much like it wasn't an overnight, you know, journey to be where we are today. I don't necessarily see it's gonna be an overnight journey to get back to where we wanna be.
I think we have an ability, and a number of different options at our disposal, that we are working through to be able to bring leverage back down to, you know, levels that we've, that we've seen historically. I think that'll again, I think that'll take time as we work through that over the next year and maybe and beyond. Some of those things that we are working on include, you know, things that we've done in the past, which include non-core dispositions. You know, outright dispositions is one part.
We're also continuing to look at JV and potential stabilized assets where we've got a number of partners that we've done over the course of several years between Mapletree and other partners, and also looking to potentially new partners. The third leg of that is also to look at the potential to joint venture some of our development projects and bring in a form of e-equity capital for, you know, the development pipeline that we have in place today.
As you think about how you got to the current leverage that you're at, was there something that didn't go right in terms of underwriting assumptions or the progression of the business? Or was it simply a function of, you know, the investment, the assets that you wanted to bring into the portfolio was worth moving up, you know, in the short term to benefit the company for the long term?
Yeah. I mean, you know, I look at, you know, I'll take sort of a, let's take a rating agency, if you will, type view on where we're at. I mean, if you look at our company, you know, back to five years ago, we are more diversified, better customer concentration, fixed charge coverage over five times . You know, I think our view is it's hard pressed to say that our portfolio isn't in better shape than it was, you know, some time ago, and therefore has capacity for slightly more leverage than where we've been historically. You know, that said, you know, I think we're, you know, we're also at a place where we had a lot of volatility in the capital markets the last years, I think we all know.
That was part of limiting options that we had available to us historically. I think between those two things, you know, I think we're at a place that we don't think is. It's harder than we wanna be, but I don't think it's, you know, when you look at the fundamentals of our business, when we look at our ability and the options we have to bring it down, when you, when you look at the development pipeline that over time will deliver EBITDA and give us an ability to naturally bring it down from that, you know, I think we feel pretty comfortable that, you know, we'll be able to manage this effectively over time.
I might add, you know, leverage is a static metric as that. We bought a non-stabilized portfolio in August that has pretty good growth potential, and leased up as occupancy commences or as leases commence. So that'll be a nice driver, as Matt alluded to and described. So that'll sort of help. Also, you know, we had a disposition guidance for this year as well. We're not all the way through it. You know, we're not as of 3Q, but we're still working toward some of those dispositions and a piece of that. Fortunately, there is substantial demand for the assets that we own, and we think there'll be ways to continue to monetize portions of the portfolio.
I'm thinking out loud with this question, but does the balance sheet on a consolidated basis not fairly represent the underlying leverage because you have consolidated assets that you might have less than 100% ownership in? You have joint ventures that you control and manage that are more mature or growing that, you know, are not in the balance sheet. Does the consolidated, if I just pull up a balance sheet in the 10-Q for you, is that not the fairest representation of leverage because of a little bit more of the complicated investment structure?
I, you know, my answer to that would be, you know, generally no, because, you know, while you don't see the way we calculate leverage and that we disclose and report it, is we include our share of joint ventures within, you know, the numerator and the denominator. I think we're, you know, and we've done that for some time, you know. I think we're giving investors and analyst community as good and clear a picture looking through not only our consolidated but also our unconsolidated ventures.
You know, I can't remember if it was in some meetings or if it was on the third quarter earnings call, but I think there was an acknowledgement that the team was gonna, you know, as rates were rising at that point, maybe take a different look or different lens on development in 2023. Any updates in terms of how you're thinking about the pace of internal development? Given some of the comments you mentioned on pricing and supply constraints in certain markets, should there be a natural benefit to the development yields when we start looking at those schedules over the course of the next 12 months?
I mean, I think the simple answer is yeah. I mean, we, you know, we have always taken a very prudent and strict approach to, you know, how we, how we monitor and how we improve development projects, you know, with an eye on, you know, our yield and an eye towards, you know, what it's gonna cost us to bring that, to bring that yield onto our balance sheet. You know, and in light of, I think, what everyone's probably should be doing, I mean, we're, you know, as we said, we're gonna take an even stricter review of our projects going forward. Again, some of that's gonna be natural in terms of there's places and markets where, you know, inventory is scarce.
All those things, you know, cost of capital increasing, some level of inflation, although I think that's fairly contained. You know, we will be looking at, I think over time, our goal would be to improve our, improve the overall, you know, quality of the projects and call it the yield within their, associated that, within our development pipeline.
In our final couple of minutes, Matt, is there a misunderstanding that you feel is out there that you sort of wanna address and, you know, raise awareness in terms of, you know, what you think that is and, you know, how you look at that topic or issue?
Yeah. I don't, I think I might go back to the survey result and I'll sort of repeat, which is probably the one, you know, that I think that we'll, I think there's a view that, you know, it's a show me story, right? In terms of being able to show organic stabilized growth.
I think, you know, I think we feel pretty confident that, you know, we'll be able to show as we've, as I've hopefully mentioned a few times, that's gonna be moving, you know, has been and will continue to move in positive direction given, you know, some of the tailwinds that are now, I think, at our back in terms of pricing, in terms of filling vacant capacity, in terms of, you know, inventory constraints that are, you know, really circle back to a pricing dynamic that should be in the developer's favor and where competition should be pricing as well. I think that's a major item. Then, you know, the other objective is, again, I think restoring the, restoring where our balance sheet is.
I think, again, showing that we have the ability to do that.
On that last point, just one follow-up. Does the, are you also seeing a dislocation between private market values and public market values? Is that helpful as you're thinking about private capital, whether it's in joint ventures for stabilized assets or for monetization or for even development?
I mean, I think that's why we view that, you know, call it that avenue, in terms of part of the deleveraging strategy. You know, I think we see that there's still a demand for our, you know, this type of product. There's, you know, there's a lot of people out there that are looking to, you know, either grow their exposure to the space or just get into this space. You know, that's why it's one of the key elements of where we're gonna be, you know, to steal from Andy, you know, have many fishing poles in the water. You know, that's one of the key ones that we're gonna target.
Well, Matt, Jordan, thank you for spending time with us today.
Yeah. Pleasure.
Thanks for having us.
Thank you. Thanks.