|Shares Out. (in M):||172||P/E||0.0x||0.0x|
|Market Cap (in $M):||5,500||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||3,300||EBIT||0||0|
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Iron Mountain’s pending REIT conversion offers investors significant upside over the next 18-months as the company’s reorganization is carried out. Assuming a target yield of 6%, the investment offers a return of over 30%. This could prove to be conservative. Looking at the comparable set of self-storage companies, we can see that the average self-storage company trades at around a 4% dividend yield and a 22.2 multiple of FFO. At these valuation rates, Iron Mountain would trade at an expected value of $71.13 per share (the simple average of $60.13 on a dividend yield basis and $82.14 on a multiple of FFO). In addition, Iron Mountain will pay $3.10 per share in special and ordinary dividends between now and 2014, for a total potential return of 130% over the next 18-months.
Iron Mountain’s pending REIT conversion offers investors significant upside over the next 18-months as the company’s reorganization is carried out. This report will cover five basic areas:
· Is this an attractive business to own?
· Can this company become a REIT?
· How much is the company worth as a REIT?
· What happens if the company is unable to become a REIT?
What is Iron Mountain’s business?
At its core, Iron Mountain is a document storage and related services business. Document storage is a necessary service for almost every company that needs to archive paper records for a future date. Some examples of the types of records are taxes, purchases and sales, disaster recovery, legal documents, and health records. While this was historically handled in-house, it has been outsourced over the years and Iron Mountain is now the largest provider of document storage. Iron Mountain provides safe and organized offsite document storage for its customers, typically in large warehouses. In addition to the basic storage business, Iron Mountain also offers a number of ancillary services, such as document pick-up and drop-off, shredding and disposal, and records management for regulatory purposes.
Is this an attractive business to own?
We believe that Iron Mountain’s business is an attractive business based on the following characteristics:
· High free cash flow: IRM produces 30% EBITDA margins and only spends about 5% of its revenue on maintenance capital expenditures each year. In addition, depreciation & amortization routinely exceeds maintenance capital expenditures, which provides a recurring cash tax shield.
· Recurring revenue streams: IRM has 88% recurring revenues from its storage and core services business. The company protects itself against pricing pressure and inflation by having built-in price escalators written into their contracts.
· Stable demand: Iron Mountain’s storage revenues have had positive growth for the past 23 consecutive years.
· International Expansion: The international business has room for both revenue and margin growth. From a revenue perspective, international growth will come from both entering new markets and market share gains in existing markets. OIBDA margins in the international business are in the low 20’s compared to the low 40’s for the North American business. Management set the target of 700 basis point margin expansion within the international business from 2010 to 2013. They remain on track to deliver on this goal.
The biggest concern is that the paper storage business will be replaced by electronic media, but we think this is unlikely to be permanently replaced and that the shift will be gradual. While the company is seeing a decline in volumes within some sectors, overall company volume has been growing. The volume growth in N.A. is flat to slightly positive while international volume growth stands at 5-6%.
Can this company become a REIT?
This trade is predicated on the belief that Iron Mountain will be allowed by the IRS to make a REIT conversion. There are several preconditions to becoming a REIT including holding at least 75% of their assets in real estate, deriving at least 75% of their gross income from rents, and paying annually at least 90 percent of their taxable income in the form of shareholder dividends. Of these conditions, we believe that the most challenging for the Company will be the real property condition. In order to meet this condition, the Company will need to reclassify its racking systems from being classified as personal property on its tax return to being classified as real property. Iron Mountain historically chose to classify its racking as personal property because there is a shorter depreciation schedule associated with this classification, which effectively reduces the current taxes that the company needs to pay. By reclassifying their assets, they will need to reverse much of the depreciation that was previously recognized on these assets, the result of which will be a cash tax payment of $225-$275 million which is payable over up to 5 years. We believe that this reclassification is the riskiest part of qualifying for a REIT and that in the absence of receiving a favorable private letter ruling allowing the reclassification of racking into real property the Company will not need to pay this large tax bill. IRM projects other one time conversion costs to be $100 to $150 million. Finally, there will be an additional $5-$10 million in annual compliance costs once a conversion is complete.
We are confident that the IRS will support the Company’s application to reclassify the racking into personal property. Our confidence comes both from speaking with a REIT tax expert and from our investigation into the historic classification of similar assets. The expert with whom we consulted expressed his belief that these assets can be reclassified as real property because he worked on the Americold REIT conversion where the IRS allowed refrigeration assets to be classified into real property. In contrast, we believe that the IRS has previously refused to allow computer racking systems to be treated as real property. In considering the differences between the two, we were told that key factors include whether the equipment is customized for the space or off the shelf and what happens when the space is vacated. As regards the computer racking, the equipment was largely off the shelf and was generally relocated when a space is vacated. In contrast, the refrigeration equipment for cold storage is custom designed for its space and is scrapped when a building is vacated. Iron Mountain’s racking is more similar to the refrigeration assets, because it is custom made for the individual warehouse space and is scrapped when Iron Mountain vacates a property. In addition the favorable comparison, we believe that the IRS is likely to look favorably on a reclassification of property that results in an inflow of cash to the treasury rather than an outflow.
How much is the company worth as a REIT?
Iron Mountain released a preliminary 2011 dividend of $2.24-$2.44 per share when it announced that it is pursuing a REIT conversion, but never gave any detail to support how it calculated the expected dividend. Based on our conversations with investor relations, we believe the company will use a 65% payout ratio for FFO when the REIT conversion takes place. We have used this to calculate our expected 2014 dividend as follows:
Operating income (2014E): 731.2
Subtract Interest Expense (2014E): 230
Pre-Tax Income: 501.2
Taxes (assume 10% rate): 50.1
Net Income from Ops: 451.1
Add Back Real Estate D&A: 185.4
Shares Outstanding: 172
FFO per share: $3.70
Assume 65% payout Ratio: $2.41 dividend
2014 Dividend: $2.41
Targeted Yield: 6%
Target Price: $40.17
Plus Estimated Special and Ordinary dividends before conversion: $3.10
Total Value with Dividends: $43.27
% Return: 34%
We believe the above target return is conservative. Looking at the comparable set of self-storage companies, we can see that the average self-storage company trades at around a 4% dividend yield and a 22.2 multiple of FFO. At these valuation rates, Iron Mountain would trade at an expected value of $71.13 per share (the simple average of $60.13 on a dividend yield basis and $82.14 on a multiple of FFO). In addition, Iron Mountain will pay $3.10 per share in special and ordinary dividends between now and 2014, for a total potential return of 130% over the next 18-months.Obviously you run the risk of REITs not trading at these types of multiples when the conversion ultimately takes place or IRM not trading to the peer average.
What happens if the company is unable to become a REIT?
Iron Mountain’s 10 year average P/E is 20.3x. With the company currently trading at 25.3x 2012 estimated EPS of $1.28 and 22.9x 2013 estimated EPS of $1.41, I see limited downside from here. If the stock were to retrace the gain seen on the day that a REIT was officially announced, the stock would trade down approximately 15%.
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