This Stock’s Dividend Could Double on Successful REIT Conversion

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Iron Mountain (NYSE: IRM) is North America’s largest provider of document storage, data protection and secure shredding services. Its stock price fell by about 28% since it issued a 8-K this month on the receipt of a “tentatively adverse” ruling from the IRS.

Why customers stay with the company

Iron Mountain has low customer churn at less than 2% per year, with the average life of a box in storage estimated at around 15 years, according to its most recent earnings conference call. Iron Mountain derives strong recurring revenue from a stable customer base for two main reasons.

Firstly, there is an element of stickiness to Iron Mountain’s document-storage business. For example, it is relatively easy to cancel a magazine subscription, which essentially means that magazines stop getting delivered to your house. On the contrary, if you choose to cancel the company’s document-storage services, all the boxes in storage will be returned. You will have a difficult task of finding space in the office to store all the documents, and implement the necessary system to be able to retrieve the documents on an as-needed basis.

Secondly, Iron Mountain benefits from high customer switching costs, as customers will have to pay a permanent withdrawal charge in addition to the usual retrieval charge for each item to be withdrawn. The inconvenience, time wastage and the additional withdrawal charges typically outweigh any cost savings from a more price-competitive competitor.

Future outlook

Iron Mountain reiterated its guidance for revenue growth between 0% and 3% for full-year fiscal 2013 in its first quarter of 2013 earnings release. Going forward, strong growth for its document-storage business is likely to be offset by reduced revenue related to the transportation of records and lower shredding activity.

In terms of organic growth, physical storage document customers should grow on the back of enhanced regulatory requirements on the retention of company records involving a longer duration and a wider range of content. Document- storage services make up only a very small proportion of the total cost structure for companies, but they help customers mitigate risks of penalties and fines related to failure to comply with document retention laws.

With the non-U.S. market accounting for only about a quarter of Iron Mountain’s revenue, there is also significant room for further international expansion. Management shared at its most recent earnings conference call, that storage rental revenue for emerging markets is growing at a CAGR of 6% to 12% compared with 1% to 3% for mature markets.

Successful REIT conversion is a potential catalyst

Iron Mountain recently revealed that it received a “tentatively adverse” ruling from the IRS relating to its REIT conversion, according to an 8-K released in June. Despite this, I am confident that Iron Mountain will eventually still be able to obtain approval from IRS for its REIT conversion, albeit at a later date than the planned conversion date Jan. 1, 2014. My opinion is that Iron Mountain fits the mold, given its similarity to self-storage REITs.

Management mentioned at its 2012 Investor Day that it expects to double its dividends following a successful REIT conversion. The increase in dividends is likely to be driven by lower taxes, depreciation and amortization and the substitution of cheaper secured financing in favor of more expensive lease debt.

Peer comparison

Iron Mountain’s peers include Cintas (NASDAQ: CTAS) and Sovran Self Storage (NYSE: SSS).

Cintas is the largest uniform rental company in the U.S., with uniform and ancillary rentals, first-aid and safety products accounting for more than 90% of its revenue. Document-management services, mainly relating to shredding, are responsible for the remaining revenue contribution. With a significant amount of the revenue in document-management services derived from the sale of shredded paper to paper recyclers, Cintas is also far more dependent on paper prices than Iron Mountain.

Cintas revised the upper end of its full-year fiscal 2013 EPS guidance from $2.54 to $2.58 on the back of record quarterly revenue in the third quarter, which was led by better-than-expected uniform rentals. I am not considering Cintas, given its cyclical exposure to U.S. job growth.

Sovran Self Storage is a REIT focused on acquiring and managing self-storage facilitates. It has 471 self-storage facilities in 25 states across the country, of which 121 of them were acquired in the past two years. Despite being a REIT, Sovran is less cyclical since demand for storage is relatively inelastic and independent of economic cycles.

Sovran raised its full-year fiscal 2013 net operating income growth estimates guidance from a range of 5.0% to 5.5% to between 6.0% and 7.0% on higher rental rates and customer traffic in the first quarter of fiscal 2013. However, I am concerned about Sovran’s gearing, which has increased from 13% at the end of 2009 to 83% now. Moreover, it is expensive at 2.6 times P/B, close to the 10-year high P/B of 2.8.

Conclusion

Iron Mountain boasts of high customer retention rates due to high customer switching costs and the element of stickiness associated with document-storage box rental. While revenue growth in recent years has been flat, I am optimistic on increased penetration of international emerging markets leading to a stronger growth outlook. It is reasonably valued at 10 times trailing-12 month EV/EBITDA and sports a 4.0% forward dividend yield. I will recommend buying Iron Mountain, with a successful REIT conversion as the catalyst for a re-rating of the stock.

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