Digital Realty Trust Inc (DLR) 2013 Q1 法說會逐字稿

Good afternoon and welcome to the Digital Realty 2013 first-quarter earnings call.

My name is McKenzie and I will be facilitating the audio portion of today's interactive broadcast.

All lines have been placed on mute to prevent any background noise.

For those of you on the stream, please take note of the options available in your event console.

At this time, I would like to turn the call over to Pamela Garibaldi, Vice President of Investor Relations.

Thank you, McKenzie.

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 investor 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, expect, may, will, should, pro forma, or other similar words or phrases.

And by discussions of strategy, 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; data center sector growth; acquisitions and investment plans; returns; cap rates; capital markets and finance plans; debt maturities; capacity and covenant compliance; the Company's growth, financial resources and success; our connectivity initiative and deployment plans; and the Company's 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, 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 operations, or FFO; adjusted FFO, or AFFO; core FFO; earnings before interest, taxes, depreciation 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.

Explanations of such non-GAAP items, and reconciliations to net income, are contained in the Company's supplemental operating and financial data package for the first quarter of 2013 furnished to the SEC, and available on the Company's website.

Again, that's www.DigitalRealty.com.

Now I'd like to introduce Michael Foust, CEO, and Bill Stein, CFO and Chief Investment Officer.

Following management's brief remarks we will open the call to your questions.

Please keep in mind that questions will be strictly limited to one per caller.

If you have additional questions please feel free to return to the queue.

I will now turn the call over to Mike.

Great.

Thank you, Pamela, and welcome to the call, everyone.

I'll begin today's call with a few comments regarding the important global network connectivity initiative we announced yesterday, and will follow up with a brief summary of our first-quarter operations.

After my remarks, Bill will discuss our recent capital markets activity and first-quarter financial results.

Following his remarks, we'll open the call to your questions.

During the Q&A today we are pleased to have with us John Sarkus, our Vice President of Network and Carrier Operations.

And he's available to answer specific questions related to yesterday's Digital Realty Ecosystem announcement.

As stated in that announcement, the launch of this strategic initiative takes our global portfolio to the next level in terms of providing customers with a carrier-neutral network connectivity offering.

From the beginning, our strategy has been to consolidate and grow a global portfolio of enterprise-quality data centers.

This included acquiring key Internet gateway network hubs, data centers that offer our customers network intensive applications, which are ideal locations to house their mission-critical business systems.

At the same time, we've grown our portfolio of corporate data centers, expanding our footprint by assembling a high concentration of properties in key markets globally.

Today, by leveraging our global footprint and operating platform, we plan to deploy the Digital Realty Ecosystem across our portfolio, providing a neutral, efficient and connectivity-rich environment for our customers to connect not only to any carrier of choice but directly to one another.

Beginning with our major campus locations, including New York, New Jersey, Boston, Ashburn, Virginia, Chicago, Dallas, Santa Clara, as well as metro London, we'll be running high count dark fiber between buildings, enabling us to offer customers a plug-and-play GigE product, as well as straight dark fiber cross-connects to customers, carriers and service providers, campus-wide.

Furthermore, this Ecosystem will provide an underlying infrastructure for carriers and service providers to deliver their entire portfolio of products and services to our customers, without them incurring the typical capital-intensive deployment costs.

We see this strategy as a critical component of our evolution that will further advance our global leadership position as the data center provider of choice, for both wholesale and retail colocation customers.

At the same time, it adds significant value to our portfolio, giving us a competitive advantage that is unmatched in the industry.

In addition to this exciting initiative, we are very pleased with the pace of leasing activity so far this year.

We achieved our highest level of first-quarter lease signings, totaling over $43.7 million of annualized GAAP rental revenue, which was also our third highest quarter on record.

The results this quarter in particular, reflect the success of our custom solutions product strategy, enabling us to capture large requirements from cloud infrastructure providers, as well as cloud-based services.

In North America, the average annual GAAP rental rate for leases signed in the quarter for our Turn-Key Flex space was $141 per square foot.

This compares to the 2012 average rate of $151 per square foot.

Please keep in mind that the fourth quarter of 2012, the average rate for leases signed was $177 a square foot, which was higher than our typical average.

We believe that the $141 per square foot is more in line with historical averages over the last couple of years.

On a per KW per month basis, the weighted average rental rate was approximately $177 per KW.

For our Custom Solutions product, the average GAAP rental rate was $108 per square foot, and the weighted average rate per kilowatt per month was $137.

The lease rates for Custom Solutions space reflect the build-to-suit nature of the projects, including the elimination of leasing risk and carry.

And oftentimes lower development costs for us based on the customer's engineering requirements and the needs for ancillary space.

The stabilized projected ROI for these leases range from 8.3% to 12%.

Markets where we saw the highest level of activity in the US included New York, New Jersey, greater Chicago and Northern Virginia.

Recently Digital Realty entered into an agreement with the Virginia Economic Development Partnership that will allow the Company and our tenants in our data center facilities, located in Loudoun County, to obtain an exemption from sales and use tax on the purchase of certain data center and computer-related equipment.

We believe making this favorable tax treatment available to our customers adds significant value to our Digital Ashburn campus.

Excluding leases that commence in the first quarter, the additional signings bring our total backlog to $84.2 million of annual GAAP rental revenue.

Another record high, of which $45.3 million is expected to commence in 2013, $21.5 million in 2014-2015, and $17.4 million expected to commence thereafter.

Please note that our backlog represents committed lease contracts that have been signed but have not yet commenced.

By contrast, excluding the leases we signed during the first quarter, our leasing prospects pipeline for our new facilities ticked up slightly from our last call, to about 2 million square feet of prospects.

This figure represents current prospects in our sales funnel to whom we've made proposals and we believe have a 30% or great likelihood of signing.

Notably, these new requirements tend to fall in two categories.

The first is the large, multi-megawatt requirement, similar to the Custom Solution leases we signed in the first quarter.

Customers that fall into this category include global financial institutions, healthcare, traditional Internet enterprises, social media cloud providers, and large system integrators.

By contrast, the second category consists of customers of varying sizes, representing an even broader range of industry verticals.

These customers are often looking to lease data center space in smaller increments, sometimes less than one megawatt.

These are our more traditional TKF, or colocation customers, that are looking for move-in ready space with the flexibility to expand, then, within our portfolio.

Offering customers a full suite of data center solutions is key to our strategy, and sets us apart from all other data center providers in the market.

In addition, our geographic footprint and scale, combined with our design and construction expertise and operating platform, enables us to meet a wide range of customer requirements, while achieving attractive return for our shareholders.

In fact, the weighted average year one stabilized return on investment for turnkey leases signed during the quarter was just over 13%.

In terms of overall supply and demand, there are handful of US markets that have had meaningful shifts -- for example, more in the three megawatts either way, up or down -- from what we provided in our Analyst Day presentation.

Moving east to west, we are now tracking approximately 36.1 megawatts of potential demand in Northern Virginia, up from 32.2 megawatts.

This compares to 24.5 megawatts of supply built or under construction currently.

Chicago saw one of the largest increases, with 34.6 megawatts of track demand, up from 18.1 megawatts previously.

This compares to an increase in supply of 6.7 megawatts, resulting in a shortfall of supply, approximately 18.3.

Demand in Silicon Valley jumped to 25.5 megawatts from 9.4 at the end of January, as did supply, resulting in a smaller surplus of supply of 4.7 megawatts.

While Dallas still shows a healthy level of demand at 25.7 megawatts, it's the only US market that decreased.

And they decreased from 32.6 megawatts we reported last quarter.

By comparison, supply in Dallas increased only slightly, resulting in a shortfall of supply of about 5.3 megawatts.

However, there have been recent announcements of planned new construction for the Dallas Metro.

Turning to our lease renewals during the quarter.

Including re-leased space, we signed approximately 233,000 square feet of data center space, at overall renewal rates that increased 0.8% on a GAAP basis, and decreased 18.2% on a first-year cash basis.

This decrease was solely due to two leases that we renewed with a particular top five customer in a New Jersey property.

They were signed at the top of the market in 2008, and the renewals were subject to very aggressive pricing by two competitors in the New Jersey market.

It is important to emphasize that these leases represent only 0.6% of our total annual revenue, and do not reflect mark-to-market for the balance of our portfolio.

From a strategic perspective, by renewing these leases we were able to expand the customer into additional data center space in the same building, actually resulting in a net increase of $2.7 million of annualized GAAP rental revenue for the property.

That said, our portfolio's geographic diversity limits our overall exposure to these markets, versus other data center landlords who are concentrated in northern Virginia, New Jersey and Silicon Valley exclusively.

For example, excluding the two leases we just noted, rates on renewals were actually up across all product types, including TKF, which was up 18.3% on a cash basis, and up 22.7% on a GAAP basis.

Powered Base Building was up 0.2%, just slightly on a cash basis, and up fully 24.5% on a GAAP basis.

Colocation, up 14.5% on a cash basis, and 14% on a GAAP basis.

And for non-tech space, up 2.3% on a cash basis, and 5.6% on a GAAP basis.

As further evidence of the strength and resiliency of our portfolio, including space that re-leased in the quarter, the combined average retention rate for data center space in the quarter was over 97%.

On a square-foot basis, over 93% of Turn-Key Flex space, representing 97% of GAAP rent, renewed at an average term of nearly 107 months.

We also renewed released 100% of expiring PBB space, reflecting 124.5% of GAAP rent, with an average lease term of over 147 months.

The healthy length of renewals, along with the annual 2.5% to 3% contractual increases, allows us to recapture any decline in cash rents after year two or three on the new term, on average, with continuously growing cash flow thereafter.

Looking at our projected renewal activity for the balance of 2013, and for the full years 2014, 2015, we project rent spreads for data center space to be relatively flat on a cash basis, and up approximately 20% on a GAAP basis.

Occupancy was 94% in the first quarter, down slightly from 94.4% in the previous quarter, primarily due to the expiration of a non-data center lease, office lease in a tech building in Fremont, California.

We're currently marketing the space to office users, and will consider selling the property once it's been stabilized.

This decrease was partially offset by the commencement of new leases totaling 27,000 square feet from our existing data center inventory, the commencement of leases from our development program totaling nearly 94,000 square feet, and the acquisition of four 100% leased buildings.

Same-store occupancy also decreased for the fourth quarter slightly, 93.7% to 93.1%, due to the same non-data center office lease expiration.

Turning now to our acquisitions program.

We began the year with a healthy level of activity that included two properties, totaling four buildings, that were 100% leased.

One of which was a sale leaseback with a major airline in the Minneapolis Metro.

The blended going-in unlevered cash cap rate for the first-quarter stabilized acquisitions was over 11%.

In addition, we acquired a development project adjacent to our Chandler, Arizona property for running future inventory in this growing data center market, as well as a development project in suburban Toronto, Canada where we are seeing significant demand from new and existing customers for data center space.

Our current pipeline of prospects for acquisition totals nearly $1 billion, including high-quality stabilized property, value-add opportunities, ground-up development sites, as well as sale leaseback transactions.

This does exclude larger portfolios that we continue to track.

Finally, I will briefly review our development program.

We continue to ramp up construction to add supply in select markets to meet current demand.

Current development activity includes nearly 549,000 square feet of Turn-Key Flex space that is 14.3% pre-leased.

Over 276,000 square feet of Custom Solutions space that is 100% pre-leased.

And approximately 564,000 square feet of Powered Base Building for future inventory in key markets.

Detailed information on our development activity by market can be found on page 29 of our first-quarter supplemental package.

We are very pleased with the strong start to 2013, and are equally excited about the new initiatives we are working on that we believe will further enhance the value of our global portfolio.

These initiatives, combined with our commitment to delivering a wide range of superior data center solutions for our customers, will continue to drive earnings growth.

I'd now like to turn the call over to Bill.

Thanks, Mike.

Good morning and good afternoon, everyone.

I will begin with reviewing our capital markets activity, and then discuss our first-quarter 2013 financial performance and guidance.

Year-to-date, we have sourced nearly $885 million of new capital, including the GBP400 million 12-year unsecured note bond offering, with a 4.25% coupon, which was equivalent to $634.9 million based on the exchange rate on the date of issuance.

And the 5.875% Series G cumulative redeemable preferred stock offering in April, which generated gross proceeds of $250 million.

Our funding strategy includes issuing debt in local currencies to provide a natural hedge, mitigating our exposure to foreign currency fluctuations in our growing international operations.

Local debt, as a percentage of regional in-country assets, range from 50% to 96%, depending upon the country.

In reviewing our balance sheet, total assets grew to $9 billion in the first quarter, compared to $8.8 billion last quarter, which is consistent with the continued growth and scale of our business.

Deferred rent increased by $19.1 million to $340.8 million this quarter, compared to $321.7 million last quarter, due to incremental new leases.

Deferred rent as a percentage of rental revenue at 7.5% remains consistent with our historical average.

Total debt increased to $4.7 billion at the first quarter 2013, compared to $4.3 billion last quarter.

We currently have $1.5 billion of immediate liquidity, including $84.5 million in short-term investments, plus funds that can be drawn on our credit facility.

If this capacity were fully utilized, we would remain in full compliance with covenants contained in the credit facility, our term loan, our Prudential shelf facility, and other unsecured debt.

In 2013, we have $219 million of remaining principal amortization and debt maturities, with a weighted average cost of 6%, which we plan to retire initially with revolver, and eventually refinance with additional long-term unsecured debt, secured debt or preferred stock.

Our net debt to adjusted EBITDA ratio was 5.5 times at quarter end, up from 5.2 times at the end of the fourth quarter last year.

This increase is due to additional borrowings to fund our development and acquisitions program.

Pro forma for the recently issued preferred equity, net debt to adjusted EBITDA is 5.2 times.

Our GAAP fixed charge ratio decreased to 3.5 times at the end of the first quarter, compared to 3.8 in the previous quarter.

Let me now turn to the quarter's financial results.

All per share results are on a diluted share and unit basis.

As stated in today's earnings release, first-quarter 2013 FFO was $1.16 per share, in line with fourth quarter 2000 (sic -- see press release "2012") FFO of $1.16.

And up 9.4% from first-quarter 2012 FFO of $1.06 per share.

Adjusting for items that do not represent core expenses or revenue streams, first quarter 2013 core FFO was $1.18 per share, $2.9 million higher than reported FFO.

These adjustments largely resulted from transaction expenses and fair value adjustments related to the Sentrum earn-out.

As I noted on our last call, a fair value assessment on the three-year Sentrum earn-out obligation is required in each reporting period, and is likely to result in some quarterly earnings fluctuation.

Changes in fair value are considered non-core adjustments.

Quarter-over-quarter, core FFO decreased slightly from $1.19 per share in the fourth quarter, primarily due to higher interest expense, as well as G&A and tax expenses, which were offset by higher NOI in the first quarter, and was up 11.3% from first quarter 2012 core FFO of $1.06 per share.

Adjusted funds from operation, or AFFO, for the first quarter of 2013 was $123.6 million, up $115.8 million in the previous quarter.

The diluted AFFO payout ratio for the first quarter of 2013 was 84.1%, up from 82.6% in the last quarter.

Adjusted EBITDA at quarter end of $212.6 million grew by 4.2% from $204 million last quarter, and was up by 23.6% from $172 million in the first quarter of 2012.

Turning now to the income statement.

Net operating income increased by $7.7 million, or 3.5%, to $227.3 million in the first quarter of 2013, and from $219.6 million last quarter.

The increase was due to incremental revenue from new leasing and acquisitions, as well as approximately $900,000 in insurance proceeds related to Hurricane Sandy.

These were partially offset by an increase in property taxes and the present value accretion adjustment related to the Sentrum earnout, as previously mentioned.

Property taxes increased by $1.3 million to $21 million in the first quarter of 2013, from $19.7 million last quarter, due to tax assessments at two properties, a portion of which was recoverable from tenants.

NOI margins, excluding utility reimbursements, increased by 60 basis points, and remain consistent with historical levels.

Likewise, first-quarter same-store NOI increased by $9.3 million, to $195.4 million, compared to $186.1 million in the previous quarter.

Same-store cash NOI, which we define as same-store NOI adjusted for straight line rents, and adjusted for non-cash purchase accounting adjustments, was $174.7 million in the first quarter, up 5.6% from $165.4 million last quarter.

The increase quarter-over-quarter was largely due to incremental revenue from new leasing, and the insurance proceeds related to Hurricane Sandy, previously mentioned.

G&A increased to $16 million in the first quarter, compared to $13.4 million in the last quarter, primarily due to certain 2012 year-end accrual adjustments amounting to $1.9 million, which reduced G&A in the fourth quarter.

Interest expense increased by $7.7 million, to $48.1 million in the quarter, from $40.4 million last quarter, primarily due to the sterling bond issuance and lower capitalized interest in the quarter.

Tax expense increased to $1.2 million in the first quarter of 2013, compared to $10,000 last quarter, primarily due to non-cash deferred taxes based on book-to-tax differences from foreign operations.

While we do not give quarterly guidance, I would like to bring your attention to a few items that we anticipate will impact next quarter's results.

First, our Series G preferred offering, which closed in early April, will result in approximately $3.4 million of incremental preferred stock dividends in the second quarter, which will be partially offset by interest expense savings of $830,000 from repayment of revolver borrowings.

Second, we expect NOI growth to be partially offset by $800,000 each quarter through the rest of the year, due to the non-data center lease expiration at the Fremont, California tech office property, which Mike referenced in his remarks.

And third, while we are not revising 2013 guidance at this time, we are closely monitoring foreign exchange rates, and plan to revisit their impact on our 2013 guidance at the end of next quarter.

Finally, in reviewing consensus estimates, there are a few items that do not appear to be reflected in some of the 2013 models.

The first item relates to $3.4 million increase in capitalized interest in the fourth quarter of 2012 from the third quarter that was due to the inclusion of additional qualified activity.

We expect capitalized interest to normalize at approximately $5 million per quarter.

Also, as a reminder, we manage to a 5.5 times debt to adjusted EBITDA.

As I discussed at our Analyst Day event in January, our 2013 guidance assumptions include $900 million to $1 billion of bond issuance, $300 million to $400 million of preferred or common, as well as a small increase in the balance of the revolver.

As I mentioned in my opening remarks today, we have issued $635 million of bonds, and $250 million of preferred stock.

We expect to access both the debt and equity markets later this year to raise the balance of capital required to meet our 2013 funding requirements.

Subject to market conditions, we may choose to issue additional common or preferred equity, or unsecured debt, to further enhance our financial flexibility.

These assumptions would exclude additional capital associated with any significant portfolio acquisition which is not included in our guidance.

This concludes our formal remarks.

Mike and I would be happy to take your questions.

Operator?

(Operator Instructions)

Jonathan Atkin with RBC Capital Markets.

Good morning.

My question centers around beta, the network connectivity focus here, and how that might influence your approach to M&A going forward.

And whether it maybe changes the likelihood that you would look to purchase a wholesale-oriented asset.

As well, I would be interested in seeing if you could ballpark the revenue uplift that you might see longer term, just within your existing properties and existing base of tenant leases, from customers that choose to cross-connect with each other, and presumably that becomes a revenue event for you.

Thanks.

Sure.

We think this is going to be a really big benefit to our customers who are either requiring network access, customers who are carriers themselves, who are ISPs, customers who are providing peering and cross-connecting, as we'll be able to pull more customers to them, as well as leasing more in our properties.

In terms of revenue, we think they that there's going to be certainly a material uplift, especially after we get all the infrastructure in place next year.

By the end of this year and then we'll realize in the end of the year in 2014.

We haven't fully defined our product set at this point.

A lot of the financial benefit will be from making our buildings even more attractive to a wide range of customers, including cloud providers, infrastructure, ISPs and carriers.

So it will help to ramp up our leasing activity.

And we expect to be able to rent more space in our network pops, in our spaces, in our buildings.

John Sarkis -- I'd like John to comment on the overall program and the benefits.

Thank you, Mike.

In looking at the size of our portfolio, we have a very large amount of buildings.

And there's attractiveness on the wholesale and the retail side.

By putting an ecosystem in place, all our buildings can accommodate both ends of the spectrum for our offering.

Any new buildings that come online will automatically fall right into the ecosystem and operate seamlessly across the entire portfolio.

In terms of CapEx or OpEx implications, because you talked about connecting buildings and cities together, and so forth, can you maybe discuss that a little bit?

Yes, the operating expense will be pretty low on the increment, because it's spread across almost our entire portfolio.

We'll probably be, on the capital side, we'll probably be investing somewhere around, probably no more than $25 million over the next nine months or so.

But then, once again, that's spread out over a very large number of buildings.

Thank you.

I'll go back in the queue.

Jordan Sadler with KeyBanc Capital Markets.

Thank you.

Good morning out there.

My follow-up there to the connectivity initiative surrounds the competition with some of your existing customers.

And to the extent that you're engaging their customers or their product offerings, or offering similar products to a greater extent, is that the nature of the business, this vertical integration that you're seeing?

And now that you're doing it basically across your core cities, that the overlap is just to an increasing extent.

It's really for us to be able to put in the infrastructure so our current customers and new customers can more readily offer their services across our portfolio.

And be able to connect, have the infrastructure and to connect everyone.

We're not going into the carrier business at all.

And John -- I'll let John comment a little more on that.

Yes, thank you.

We are not -- I over-emphasize the word not -- becoming a network provider.

What we're doing is we're making it easier for carriers and service providers to deliver their services to our customers across our entire portfolio.

And that is what our customers have been asking and looking for.

And our carrier partners as well as our data center industry partners there are looking for ease to navigate through our entire portfolio.

This ecosystem will provide them with the seamless cost-efficient and secure environment that they look for.

In other words, you can get to -- from hopefully any building in our portfolio to virtually any carrier, any meet-me room, any cross-connect peering platforms, any cloud infrastructure provider.

And then that way, should be driving more business for everyone who resides or has facilities in a Digital Realty portfolio property.

Emmanuel Korchman with Citi.

Good morning, guys.

Just had a question on your international portfolio.

It looks like in early March you made an investment in Mexico.

But I didn't see anything mentioned in the release or in your prepared remarks.

Just wondering what that was and what your plans was for that market.

Sure.

We think there's good opportunities for us in several locations in Mexico.

The investment that we're making -- it hasn't fully closed yet -- is a very small minority investment, about 8.5%, in one of our customers in Mexico City, who's a metro fiber provider.

And we've done work for them on data center design and project management.

And what this will let us do, making a small investment, but gives us the ability to have a good lens into the growth and evolution of the Mexico market in Mexico City, Guadalajara, Monterey.

So we can have a good idea, a front row seat, if you will, on how that market is growing, and where demand is for our wholesale products.

So that's the genesis of that initiative.

Vance Edelson with Morgan Stanley.

Just going back to the capital side of things, the maintenance or recurring CapEx trended a bit lower.

Could you just walk us through what exactly drove the decline, and perhaps what we should model going forward?

Yes, that's probably -- really reflects first-quarter seasonality, if you will, on deploying capital.

I think will generally be in line with our projections over the course of the year.

Okay, thanks.

Rob Stevenson with Macquarie.

Good afternoon, guys.

You did another sale leaseback this quarter.

Can you talk about what the demand is for these transactions and what your pipeline looks like, given the likely changes to lease accounting making these type of deals less advantageous for the lessee?

We've had good activity.

We did the Bouygues telecommunications wireless company outside of Paris.

That was in December.

This is the second sale leaseback that we've done with Delta Air Lines.

We're talking with other corporations, as well, who are interested in freeing up capital from the balance sheet.

So we're actually -- both in Europe and in the US.

It's hard to predict how many of these sorts of deals we'll be doing this year and next year.

But we've certainly seen increased interest from corporate owners.

That's for certain.

Rob, it's not accounting-driven at this point.

It's cost of capital-driven.

Lessees just sees an opportunity to obtain capital less expensively from us than from their banks.

Matt Rand with Goldman Sachs.

I have a couple on lease expirations.

First, as a quick clarification, for your Turn-Key and Powered Base Building lease expiration schedules, it looks like you added a month-to-month category this quarter.

And it looks like some of the leases that went into that bucket were actually previously in the thereafter category as opposed to in 2013.

Am I reading that right?

I'm not sure.

I don't have the detail.

I don't think so.

I think the month to month, though, is really more focused on the co-lo.

Okay.

Because it was actually a pretty big step-up in Turn-Key and Powered Base.

And if you look at the number of leases in the thereafter category, they went down.

So I was just trying to get a feel for if you were consolidating leases or re-classing them or something.

No.

No.

We'll get back to you with the details but that wasn't the case.

Vincent Chao with Deutsche Bank.

Hello, everyone.

Just a question going back to volumes, understanding it was a very strong quarter for you guys, driven by Custom Solutions.

But just wondering what you're seeing on the TKF front.

That seemed like it was maybe a little lighter than it's been on an historical basis in terms of first quarters.

And just maybe some color on why Custom Solutions demand seems to be a little bit stronger right now.

I think we've been seeing certainly over the last three quarters more interest.

I think as we came out of the recession, and demand started to build in the second half of 2012, we're seeing companies looking at some large requirements out there, that tend to be more of a build-to-suit nature and more of a custom-design nature.

I think the relative breakout this quarter between Turn-Key Flex and Custom Solutions was unusually large.

We're dealing with a very small data set.

So I think over the course of the year, it's going to even out more, where we'll be leasing relatively more Turn-Key Flex space as we get further into the year.

But certainly the Custom Solutions, because we have the ability, the design, the project management, the engineering expertise, really gives us the ability to address a big part of the market that a lot of folks don't have ready access to with whom we compete.

Jonathan Schildkraut with Evercore Partners.

Thanks for taking the question.

It only has 11 parts.

No, seriously.

I'd like to ask another question in terms of the interconnect product.

For a long time you guys have run Internet gateways.

You've had your colocation products so you could do some interconnect there.

And the ability to tie together your data centers has always been there you through the use of the carriers or the fiber backbones that led into your centers.

What's evolved from a demand perspective today that brings a call to action for this?

Is it the need to move workloads in and out of, say, cloud environments?

Or is it the desire to extend the Internet gateways to the other data centers?

I'm just trying to understand why now is the right time for the investment.

Thanks.

Sure.

And I'll let John jump in on this.

In terms of timing, we probably should have done it two years ago, in anticipation of this growth, great growth in cloud.

But we think that we have an opportunity now.

We're not late.

And as we're seeing more and more with new data centers coming online, our customers want the ability to have a ready solution from a range of carriers and ISPs and cloud infrastructure providers.

And we want to be able to present that to customers, either existing customers, as well as new customers coming into new buildings.

And we want to have that package of services in a very organized, well-defined manner.

I'll let John embellish on those thoughts.

Thank.

That was a very good question.

As you can see the evolution of the data center market, bandwidth has created a dependency on the data center provider.

It's become a much more critical component than just space and power.

By providing our customers the ability to access their networks, and the size of the bandwidth that they require, is what the driving component here to get this rolled out as quickly as possible.

We've seen a lot of questions come in about very large bandwidth demand, and structured deployment in a customized solution across our data center portfolio.

Where we have one location would act as more of the production environment, whereas some of our other locations would act as a disaster recovery component, with less critical equipment.

But the two need to be tied together.

By providing this ecosystem, we will now be able to do that for our customers in a one-stop shop format.

George Auerbach with ISI Group.

Bill, just a question on the balance sheet.

You mentioned that the leverage is creeping up, and it will creep up a bit more through the year.

And you are putting more debt in the line of credit than you have in the past.

Why the change in the balance sheet strategy over the last six or nine months?

And what level, from a net debt-to-EBITDA, or fixed charge coverage, and also floating rate debt exposure are you comfortable with?

George, I don't know that there's been a change, per se, other than we went to the rating agencies in the fall.

And we talked to them about running the Company at 5.5 times versus 5. And they were comfortable with that.

And we think, given the scale of the Company's operations, and diversification across various verticals and tenants around the world, that that was totally appropriate.

Frankly, if you look at where most REITs, BBB-rated REITs run their leverage, I think 6 is probably more typical than 5.5.

So 5.5 is still on the conservative side.

We ended up, at the end of the quarter, at 5.5.

But as I said in my remarks, we very consciously did a preferred.

We weren't sure whether we were going to do it at the end of the quarter or the beginning of the second quarter.

And that took the leverage back to where it was at the end of the year, which was 5.2 times.

And because we are managed to a 5.5, that doesn't mean that we won't go over occasionally.

But we're targeting 5.5 times debt-to-EBITDA.

Your question, too, was fixed charge coverage.

Our target there is to stay in the high 2s or above.

So the fixed charge did go down in the first quarter.

And that was primarily due to the sterling bond offering that was done in January, which had a 4.25% coupon.

Gabriel Hilmoe with UBS.

Hi.

Thanks.

Can you talk a little bit about the occupancy drop at 111 8th?

And, Mike, you may have mentioned this in your remarks and I missed it, but what do you think the mark-to-market is on rents for the portfolio today?

111 8th, we really didn't have much of a drop.

We had one customer who moved into one of our other buildings, and then we're re-leasing that.

I think we've already re-leased that space.

It will commence second quarter.

Commencing second quarter, this quarter.

So, yes, you just caught that building in between re-leasing.

So that space at 111 8th is actually 100% occupied now.

And in terms of mark-to-market, we talked about how we're seeing renewals over the next couple years being flat on a cash basis, very high rate.

So historically high rates, based on the cash uplift that we've been enjoying in the leases, on average.

So we think that mark-to-market on a GAAP basis is probably -- and this is really just a projection on my part -- you're talking 5% to 10% probably, maybe.

At least I would think, in that case, on a GAAP basis.

Maybe even slightly more.

It depends on the product class.

PBB will have a much higher output than Turn-Key.

Right.

John Stewart with Green Street Advisors.

Thank you.

Bill, could you please shed a little bit of light on the Sentrum earnout, maybe specifically how it's performing relative to pro forma?

And help us tie that back to the earnings noise.

And then, Mike, came across a story recently indicating that you guys were prepared to make your initial foray into mainland China next year, with sites selected in Shanghai and Beijing.

Can you talk about, first of all, how accurate that might be?

And the underwriting process and the type of returns that you would target in mainland China.

John, relative to the earnout, the earnout is a function of both the rents achieved, the absolute level of rents, the timing for those rents, and the capital deployed to achieve those rents.

So, that's what goes into the formula to determine whether or not it's a plus or a minus.

Last quarter it was a plus.

And this quarter it's a minus.

But most of the changes here are going to be accretive.

But we don't consider that core.

It's just -- again, it's noise.

We have another two years and a quarter left of that.

And the amount of the adjustment will, because it's a present value calculation, the amount of the adjustment declines with the passage of time, as well.

So there will be less as we get closer to the end of the earnout period.

And in terms of our China initiative, we are speaking with -- as we have been over the last couple years -- and meeting with different service providers, both managed services, network providers, cloud providers, with whom we might be able to strike up a partnership.

So, at this point, we're still in relatively early stages of discussion.

But we have targeted a couple of prospects, potentially would be good partners with us in a JV.

We feel very strongly in China that to be successful, we want to be partnered with folks that are providing data center services in the marketplace.

And have the proper licenses for power and fiber, which is so important.

So it's still relatively early days but we're definitely interested in that market.

It's many markets, obviously, in China.

And probably the three most likely forays would be Shanghai, Beijing and Shenzhen.

But we're not at the point where we have site selection or agreements drafted or anything like that.

Tayo Okusanya with Jefferies.

Emmanuel Korchman with Citi.

Michael Bilerman speaking.

Mike, just as you think about this interconnectivity that you're building out, just given the fact that data center rents and Powered Base Building rents are different across the US and internationally.

Do you anticipate a potential shift of tenants that want access to Digital and the benefits that you'll have from the interconnects, shifting to lower-cost locations?

And how you think that evolves.

Understanding that there's a benefit to going into it.

But do you think that there may be a shift in demand going to lower cost locations.

That's number one.

Number two, just for Bill, you talked about how doing local denominated debt in different geographies reduces your FX exposure.

And I'm just curious, as you think longer term, you look at your largest global REIT peer, Prologis, they want to be 80% to 100% US exposed, but have a 60% global ex-US portfolio.

So I'm just curious, do you eventually want to move to that, as well -- being 100% US exposed with a large global exposure?

I'm not exactly sure what your question there is, Michael.

I will tell you that our philosophy is to, to the extent we can, we'll put more debt against the foreign assets to provide maximum natural hedge.

So right now our largest market exposure is the UK.

We're a little over 50% there.

Most of the Asian countries are in the 90%s right now in terms of debt -- local debt as a percentage of the net asset in that region.

So it sounds like we might have a different philosophy than Prologis, if I understand your question correctly.

Let me go ahead and answer Michael's part of the first question regarding locational decisions.

I don't think we're going to see a significant shift.

And I'll let John jump in on this.

But we're seeing across our major markets folks who need to be in London and New Jersey and Virginia still want to be there.

And there's folks who want to be in Central Time Zone or in lower-cost environments, and are looking at Dallas and Austin and Houston.

And there's folks who need to be in Silicon Valley.

So I don't think we're going to see a shift away from particular markets.

I think we're going to see more opportunities for our portfolio broadly.

John, what do you see there?

Yes, I'd just like to add one thing to those comments.

When looking at a market, you have different buildings that are gateway buildings and non-gateway buildings.

We will be re-leasing the ecosystem to level the value of our portfolio buildings across the entire platform.

Making some of our properties much more valuable than they are outside the ecosystem.

So if you're looking at a market where there's three major gateway buildings, and then we have a number of other buildings outside the gateway, those buildings become that much more desirable.

And offer what I mentioned earlier, the customized solution of splitting footprint across the region and our buildings.

I hope that answers the question.

So a lot of it is diversification within a region, or across major markets.

But not necessarily going to tertiary areas, at least based on the customer base that we're seeing growing quickly for us.

Matt Rand with Goldman Sachs.

I promise this one's easier.

I appreciate the color in your prepared remarks on the cash spreads on the leases signed during the quarter.

But I'll confess, when I saw the supplement this morning I was a little surprised to see the big negative number on Turn-Key.

What it seems like from your remarks and from everything we're hearing in the market is there is increasing divergence between different markets, between different density levels, between all sorts of things.

And there's two key pieces of information that we don't know about your portfolio.

One is where the expirations are over the next couple of years.

And the other is what the kilowatt levels are across the portfolio, as opposed to square footage, which really actually drives your leasing.

Can you provide some color for all of us on the call so we have a better sense of how the next couple years might unfold in terms of lease roll?

We've got a lot of information in the supplementals about the rolls.

It's spread out across a lot of different markets.

So it's hard to make a broad characterization.

Other than, on average, we think we're in a good position, broadly, on the renewals.

And folks want and need to stay in our buildings.

So it's difficult on this call to draw broad conclusions because we are in so many different markets and, as you know, with different product types.

Bill?

I think in terms of broad brush it's safe to assume that the Powered Base, as I said earlier, is going to have a pretty substantial uplift as they renew.

And there's several factors that are driving that.

It's not just where the rents were struck and the timing for the initial rents, but typically that was -- those are 10 year to 15 year initial deals, so they were some time ago.

It's also because the tenants have invested significant capital in that space and they tend to be quite sticky as a result of that.

The Turn-Key rents started out at a much higher level.

But, once again, the tenants, although they didn't invest in the data center infrastructure the way the Powered Base customers do, they still have significant investment in their space.

We covered this on our Analyst Day.

Relocation costs are significant even for a Turn-Key customer.

And for that reason, we think it's -- with certain exceptions.

And we had one of those exceptions this quarter for a major customer that was under attack in a market where there's been some weakness.

On a percentage basis, it was small overall.

But with certain exceptions we would expect that the cash rents on Turn-Key would be roughly flat on a mark-to-market basis across the portfolio, regardless of region.

Tayo Okusanya with Jefferies.

Yes, good afternoon.

That explanation to Matt was helpful.

Just a couple of things, though.

Just in regards to the renewals in the New Jersey market, and the much lower rents that those were signed for to keep those tenants, can you just talk a little about overall competition in Jersey and what you're seeing?

New Jersey, it's definitely a good market because you've got the financial services and many large corporations in the region.

The challenge is there's a couple, three competitors who are very aggressive on pricing.

And have had challenges getting traction with their developments.

And thus our being aggressive in that market.

So I think that's probably the market we're seeing a little more downward push on rents.

I don't think rents are going down further.

I think they stabilized probably last quarter.

But there is, in that particular market, probably a couple of folks who are trying to grab market share and trying to get absorption, and they've had some challenges.

And there are no further questions at this time.

Great.

Thank you very much.

And thanks, everyone, for your time and good comments and questions today.

And thank you to the Digital team.

It's another quarter well done.

We're really excited about our Digital Realty Ecosystem.

I think it's going to bring a lot of value for our customers and for new customers.

Thanks very much.

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