Exclusive: How QTS Plans to Keep Momentum After Two Years of High Growth

QTS Realty Trust has been one of the fastest-growing publicly traded data center REITs since its 2013 IPO, and its shares returned more than 80 percent price appreciation to shareholders for the last two years.

Can the company maintain this momentum going into 2016? That's the question we asked its CIO Jeff Berson and COO Dan Bennewitz in a recent interview.

Last week, JP Morgan selected QTS as one of two data center REITs with an Overweight rating, along with sector peer CyrusOne.

Read more: JP Morgan: Data Center REIT Stocks Undervalued

Carpathia Integration

QTS completed the integration of Carpathia, the colocation and managed hosting company it acquired last year, earlier this month, expanding its geographic footprint domestically and internationally, adding a substantial managed hosting capability, and gaining a lot of government customers. The international markets where QTS now has presence are Toronto, London, Amsterdam, Hong Kong, and Sydney. Carpathia added over 230 new logos to the QTS tenant roster which has now grown to more than 1,000 customers worldwide.

Read more: Why QTS Dished Out $326M on Carpathia Hosting

Bennewitz said sales efforts have now been combined into one product team. He confirmed that QTS intends to take a "measured approach" to migrating former Carpathia customers in leased facilities to QTS-owned campuses.

QTS will work with customers on a case-by-case basis to assess the pros and cons of moving over to a larger and potentially more efficient QTS facility. Bennewitz hopes that by "being a good partner to customers," QTS will reduce potential churn, as many Carpathia tenant lease terms expire in 2016 and beyond.

The Big Picture

Businesses are showing an increased interest in outsourcing in-house data center operations. According to Berson, QTS will reap the benefits as this slice of market gets bigger.

There is one consistent theme that QTS is hearing from nearly every CTO during lease discussions. Their IT stack is becoming more complex, and there is considerable uncertainty on how best to approach colocation and cloud for different applications.

QTS is actually an acronym for Quality Technology Services, the company's prior name. Since 2003, it has steadily built its capability to offer a "full hybrid IT offering in-house." Berson emphasized this capability was the reason QTS is now engaged in higher-level discussions with customers in 2016.

In-House Solutions

QTS offers customers a suite of solutions it calls C3, C1 being wholesale data center space, C2 retail colo, and C3 cloud and managed services. Notably, over 40 percent of its monthly recurring revenue comes from customers who utilize more than one product.

Berson pointed out that while growing data center usage is a demand driver for the entire industry, QTS and "the other larger incumbents" have been successful in landing "more than their fair share" of the deals in the marketplace. The C3 cloud and managed service offerings are one of the main differentiators for QTS as it competes for data center customers.

One-Stop Shop Allows Flexibility

QTS customers are concerned about the future hybrid environment they might require as needs evolve, taking into account: multiple vendors, managed services, hosting, direct connect, consulting services, compliance and security.

COO Bennewitz emphasized that customers don't want to become locked into a one-size-fits-all solution. When they contract with QTS, there is flexibility to modify the contract as needs change. One example would be reducing a footprint while adding additional services.

Berson contrasted the QTS one-stop approach with situations where customers have entered into a contract to lease space from a landlord, while critical services are being provided by third parties. Since the revenues are going to multiple entities, it isn't a simple matter to modify the agreements and go in a different direction once the deals have been inked.

Some data center companies offer colocation and hosting options for customers but lack a wholesale solution for larger-footprint data center deployments. Conversely, not all data center REITs that offer Infrastructure-as-a-Service have engineers on staff to help customers migrate their IT stack from company-owned facilities into a colo and cloud environment and offer assistance with hybrid-cloud solutions.

Business Drivers and Updates

Booked-Not-Billed - The record C1 wholesales leases signed in 2014 continue to provide visibility into future growth. QTS continues to build out large chunks of this space in phases. Moving forward, Bennewitz expects this should result in a "normalized" book-not-billed in the $30 million to $40 million range.

Healthcare - Concerns regarding HIPAA compliance and security in the healthcare industry have resulted in some big wins for QTS in the Atlanta market. Hospitals faced with investing large amounts of capital to upgrade legacy data centers are attracted to solutions available at the QTS Atlanta-Metro campus. In addition to a secure solution for data, secondary gains include freeing up capital for high-priority projects and freeing up physical space on the hospital campus.

Federal Government - While governmental agency business is "an exciting potential opportunity," a lack of visibility regarding the timing of any lease signings makes it difficult to model future revenue contributions.

Chicago - QTS continues to execute on its strategy of purchasing underutilized infrastructure-rich properties at a steep discount to repurpose into data center campuses. Former "brownfield sites" in Atlanta, Dallas, and Richmond, Virginia, are currently in operation as state-of-the-art QTS data center campuses.

Bennewitz confirmed that the initial phase of the former Chicago Sun-Times Press facility should come online in the second half of 2016. Initially, 8MW of raised floor will be developed with an additional 47MW available for expansion.

In a similar fashion to the first phase in Dallas last year, QTS has begun construction without an anchor tenant already signed. There are property tours being conducted, and Bennewitz is seeing considerable demand in Chicago for a brand new data center with access to long-haul fiber networks located "minutes away" from the major downtown carrier hotel 350 East Cermak.

New Jersey - QTS owns the $75 million McGraw Hill Financial data center located on a 194-acre campus near Princeton, New Jersey. In July 2014, the company entered into a 10-year lease and strategic alliance with global IT powerhouse Atos SE. QTS provides McGraw Hill with IaaS and critical facilities management services alongside Atos IT service offerings.

McGraw Hill also leases space from QTS in Jersey City. QTS does not believe that the spin-off of the MHFI educational services unit will have any negative impacts moving forward. It is too early to speculate if this glass might actually be half-full.

Notably, the Atos strategic alliance has already paid dividends for QTS in Dallas. Atos is headquartered in Bezos, France, and has over 17,000 employees based in 52 countries around the globe.

Bottom Line

The QTS business model has delivered stabilized unlevered returns of at least 15 percent ROIC for the past nine quarters. This is a blended average of all of the QTS campuses, with the existing 12MW MHFI facility delivering north of 10 percent ROIC at one end, and the 36MW 89-percent-built-out Atlanta-Suwanee site pumping out a 27.4 percent ROIC at the high end.

As each new phase is developed, the ROIC increases for QTS, which creates a virtuous cycle. In addition, the QTS campuses have over 235 acres of land for expansion.

In Dallas, where it has access to 140MW, QTS opened a 54,000-square-foot phase within a 292,000-square-foot powered shell. In the 110MW Richmond facility it has 121,600 square feet within a 557,000-square-foot powered shell, which delivers 12.8 percent ROIC with only about one-fifth currently built-out. Atlanta-Metro (72MW), is 79 percent occupied and delivers an ROIC of 17.6 percent.

The more mature campuses are supporting growth of the newer QTS pins in the map while still delivering an overall 15 percent stabilized ROIC for shareholders. Berson quipped that he doesn't worry that he will "wake up each morning" and discover that QTS has decided to change its business model or product.