Iron Mountain Moving Into Data Centers – The 8% Yield Looks Solid

There is one category of REITs that is always hard to evaluate because it contains companies that own a variety of different property types. For example, Innovative Industrial Properties (IIPR) owns facilities where cannabis is grown. We bought this stock in January 2018 and downgraded it to Reduce on June 10th, 2019 after a 260% return. Since then the stock is up another 24% and while we missed that last move, we’re comfortable with our decision and have no regrets – even in hindsight.

In any case, these ‘specialty’ types of properties are so unique that it’s difficult to group them in with any other type of property. The same holds true for a number of other property types so if there is any REIT sub-sector where bottom up investing is critical, it’s the Specialty REIT sub-sector, which according to NAREIT, now has 12 components – most of which are hardly comparable to any other one. They include companies like Gaming and Leisure Properties (GLPI)EPR Properties (EPR) – which we recently coveredOUTFRONT Media (OUT)Geo Group (GEO), and Safehold (SAFE), to name a few. 

At the moment they make up just $49 billion in market cap across the entire sub-sector, making it one of the smallest of the REIT sub-sectors but likely to exhibit higher growth in coming years. It’s the uniqueness of the properties and the niches they operate in that has piqued the interest of investors. 

This shift towards non-traditional property types started several years ago, however, with the growth of ecommerce, data demand, and everything ‘digital’. 

Non-traditional REITs gaining popularity

While the traditional pure play real estate-focused REITs comprising office, industrial, retail, and residential continue to form the bulk of REITs, non-traditional REITs such as infrastructure, data centers and timber are gaining popularity among REIT investors – in addition to those mentioned above. The changing landscape is shown by the significant reduction in cumulative weights of the traditional REITs mentioned above from ~57.0% in 2009 to ~47% in 2018 in the FTSE NAREIT All Equity REIT Index whilst non-traditional REITs (timber, data centers and infrastructure) gained a significant share of overall weight over the same period (from 0% to 23%).

Source: NAREIT

While growth in the traditional REIT sectors has matured, it remains solid in the non-traditional space such as data centers and infrastructure that target the new age economy and ecommerce. In the U.S., the infrastructure space is an oligopoly with three large cell tower players dominating the market. Data center REITs rank among the fastest growing REITs, as increasing data traffic due to ecommerce, internet of things & cloud-based services create huge data for data centers. According to Invesco, data centers demand continues to outpace supply in the U.S. and slower supply growth outside the U.S. reflect growth prospects in the sector. 

One such non-traditional REIT is Iron Mountain Inc, (IRM), a global leader in the Records and Information Storage (RIM) industry, a niche non-traditional REIT sector, and of late, shifting its business mix towards the data center business. The company can be categorized as a hybrid industrial/storage/data center REIT. Unlike traditional data storage or self-storage sectors, the company generates core storage rental revenues from renting out space in large buildings to corporations (versus individuals in self-storage) for storage of physical records and digital medial tapes, along with meaningful service revenues from associated information management. The company converted to REIT status in 2014 and continues to sharpen its focus on REIT-relevant revenues, with focus on expanding into Data Centers as well as complementary adjacent businesses such as Fine art and Consumer storage. A slowdown in the mature RIM is also prompting IRM to expand into adjacent businesses. 

Market leader in records management storage platform

With ~700 million Cu. Ft. of records spread across 1450 facilities in 50 countries and serving 95% of Fortune 1000 companies, Iron Mountain Inc. is by far the largest player in the global physical records and data backup media storage market and related information management services. The $2.6 billion acquisition of Australia-based records and information management company, Recall with presence in multiple countries, solidified IRM’s position as the global leader in records storage by significantly expanding its presence in the fast growing Asian market. Although several competitors are present in this specialty REIT space, none of them have the size and scale of IRM. For example, in North America, Iron Mountain’s records management business is ~10x larger than the second largest competitor, Access.

Source: IRM Investor Presentation June 2019

The records storage and information management (RIM) business is IRM’s core segment and accounts for the bulk of revenues and gross profit (80%). Within RIM, Storage rentals for physical records (paper documents or computer tapes) and digital information is the key driver of financial performance and the relevant REIT metric for dividend distribution. Storage rentals account for ~60% of revenues and 80% of gross profits, and have high EBITDA margins of 75%. Services account for about 40% of revenues but carry lesser margins (10-15%) and primarily consist of secure shredding operations (10% of revenues) and others (handling of records; scanning, imaging and document conversion services; consulting services; and data protection & recovery).

Source: IRM Investor Presentation June 2019

Fixed contracts and high customer retention makes IRM’s storage platform a durable and recurring business. The majority of revenues come from storage rentals (usually monthly) through fixed contracts ranging from one-five years. The segment also enjoys high customer retention of ~98% and strong physical records retention with 50% of physical records that entered 15 years ago are still with the company.

Source: IRM Investor Presentation June 2019

Despite being durable, the storage rental business is mature and growing at low single digits. The physical information storage is particularly hard hit as consumers continue to shift from paper and tape storage to alternative technologies. These trends continue to weigh on storage volumes as well as services that rely on activity rates of stored records. For example, the segment witnessed volume declines in its North American RIM business in 2018. Additionally, corporations are increasingly deploying their own storage and information management services, which could limit growth in outsourcing of storage business to companies such as IRM.

Source: IRM Earnings Supplemental Report 1Q2019

To deal with the concerns in its core segment, IRM has, of late, been increasing its focus on its growth portfolio consisting of Data Centers, Emerging Markets and Adjacent businesses (discussed in the next point). At the same time, IRM continues to focus on efforts to drive and sustain growth in RIM through various strategic initiatives. In the developed markets, the company would focus on sales efforts to support sales to new customers, gain incremental volumes from existing customers, and employ successful revenue management (price increases). As can be seen in the chart below, despite volume declines, IRM was able to register organic growth in storage rental revenues aided primarily by price increases. In the developing markets where the RIM business continues to witness strong growth, IRM plans to aggressively expand its RIM business primarily through acquisitions.

Source: IRM Form 10-K 2018

Shift in business mix towards faster growing businesses

As growth slows down in IRM’s core records storage segment, IRM is increasingly focusing on faster growth businesses including data center, emerging markets, and adjacent segments, collectively called as ‘growth portfolio’. This business shift mix has already gained momentum with ~26% of revenues generated from this portfolio in 2019 with organic growth of ~5% (versus 2% for developed portfolio), and further expected to reach 30% of revenues at 5-7% organic growth (versus ~3% for developed portfolio) by 2020.

Source: IRM Investor Presentation June 2019

Data centers would be key driver: IRM continues to aggressively pursue expansion of data centers through acquisitions to offset slower growth in the RIM segment. Through numerous acquisitions including the key IO Data Centers’ U.S. operations in 2018 as well as Fortrust and Credit Suisse (2017) and EvoSwitch (2018), data center business has attained significant size – 13 facilities across U.S., Europe and Asia with ~103 MW of leasable capacity of which ~91.4% is utilized. With more acquisitions planned and expansion of existing facilities, the capacity could grow multifold over the coming years. Consequently, data centers contributed to ~6% of IRM’s total revenues as well as EBITDA in 2018 from just 2% in 2017, and by 2020, the segment’s contribution is expected to increase to 10% of revenues and EBITDA. Leveraging its track record and existing customer relationships in the records storage segment, IRM continues to generate leasing customers for data centers. In 1Q19, IRM signed new or expanded leases for almost 4 megawatts versus 3.3 megawatts in 4Q18. Additionally, there exists potential for cross selling opportunities, with ~40% of new deals in Q1 pipeline generated by the IRM sales team.

Source: IRM Investor Presentation June 2019

RIM expansion in emerging markets: Contrary to the developed North American market, records storage business is largely untapped in emerging markets (central and eastern Europe, Latin America, Africa and Asia), presenting significant opportunity for IRM. The 2016 Recall acquisition helped IRM to expand to multiple emerging market countries, and IRM is open for further acquisitions to expand its presence in the emerging markets. Organic growth in these markets has been in double digits compared to low single digits in developed markets. Growth coupled with inorganic expansion will likely result in increasing share of emerging markets in overall revenues. However, EBITDA margins in emerging markets are just ~27%, much lower than the ~75% in the North American market, but could improve to 30% by 2020 as the business matures.

Faster growing adjacent businesses: Fine arts storage, entertainment services, and consumer storage are the adjacent complementary businesses that IRM continues to expand. IRM has acquired five companies over the past three years to expand its operations for storage of fine arts and other valuable items, with presence in the U.S., London, Zurich, and Hong Kong. Future expansion plans for Fine arts include Amsterdam as well as London, Chicago and Hong Kong. Entertainment services target content production and media storage needs in the studios, sports and marketing industries, and currently has operations in Los Angeles, New York, London, Amsterdam, Paris, Toronto, and Hong Kong. In the consumer storage space, IRM formed a partnership with MakeSpace that combines MakeSpace’s technology platform for consumer storage with Iron Mountain’s storage, transportation and logistics operations. Following the partnership deal, MakeSpace became a storage customer of Iron Mountain with an initial 2.1 million cubic feet of consumer storage.

While small, these adjacent businesses are growing at a rapid clip as evidenced by a surge in volumes – volume doubled to 5.1 million cubic feet over the past two years in the Fine arts and Entertainment segment while it reached 2.5 million cubic feet in 1Q19 from 0.1 million cubic feet in 1Q17, due primarily to the addition of 2.1 million cubic feet from the recent MakeSpace partnership.

Source: IRM Earnings Supplemental Report 1Q2019

Robust dividend yield

Post the conversion to REIT in 2014, IRM has focused on dividend growth as a priority while retaining the flexibility to deploy growth capex. Since the conversion, annual dividend growth has averaged ~7% (including the outsized 11% growth in 2016) but the past year (2018) growth has been at 4%, which it can maintain in the foreseeable future on growing EBITDA and cash flows. The dividend growth should track the 5% targeted EBITDA and AFFO growth, which seems achievable through the company’s credible strategy of maintaining stable growth in its core records storage business, aggressively expand growing data center business (which will contribute 10% of revenues in 2020) and investing in complementary adjacent businesses. Cost efficiencies should also meaningfully contribute to EBITDA and AFFO.

Source: IRM filings and 3Q18 presentation

At its current market price of $30.88 (as on June 27, 2019), the divined yield is ~8%, among the highest in the RIET space and thrice the average dividend yields for data center REITs (2.68%) and industrial REITs (2.85%). Part of the reason why the dividend yield on IRM has been consistently high versus pure play real estate REITs is that IRM, being a non-traditional REIT (with meaningful services revenue and low real estate value) has not fully caught investors’ focus. Another reason why the dividend yield has increased of late is the bad first quarter results, which drove the company’s shares nearly 9% down on the result day. With management reiterating the guidance for full year 2019 despite the weak first quarter results, investors can expect a decent dividend payout for the year.

IRM estimates the cash available for dividends and discretionary investments in 2019 at $750-$830 million and intends to pay $703 million or $2.44 per share (assuming 286.6 million shares) to common shareholders with the remaining $60-$130 million for discretionary investments (including $250 on data centers) which are expected to total $380 million. The shortfall of ~$250-300 million will be funded by debt. Assuming IRM’s estimated AFFO of $900 million for 2019, the AFFO payout comes out at 0.8x, consistent with 0.7x-0.8x over the past two years.

Source: IRM Investor Presentation June 2019

1st Quarter 2019 Results

Iron Mountain reported a mixed set of numbers for 1Q 2019, with revenues largely in line (driven by acquisitions as well as a firm organic growth in storage) with expectations while EBITDA and earnings well below expectations due to higher labor costs in the shred business and establishment of a new global operations support team.

Consolidated revenues rose 1.1% from $1.04 billion to $1.05 billion and cost of sales increased by 2.9% from $448.7 million to $461.5 million largely due to facilities and acquisition costs. Segment-wise, consolidated storage rentals segment did well (+1.8% YoY) and consolidated services segment underperformed (-0.1% YoY). The 1.8% increase in the consolidated storage rentals was the result of both organic and inorganic growth initiatives. The acquisition of Global Data Center Business segment contributed 3.1% to the storage rental revenue growth rate; while organically the Company grew its storage rental revenue by 2.0% with North American RIM Business contributing 1.4% while Western European Business contributed 3.3% and Other International Business segments 4.6%. North American Data Management Business segment underperformed due to lower storage volume (-2.9% YoY). Global records management net volumes (incl. acquisitions/divestitures) grew by 1.5%, supported by net volume increases of 2.2% and 7.3% in Western European Business and Other International Business segments, respectively, partially offset by a net volume decrease of 1.2% in North American Records and Information Management Business segment.

Services revenue declined by 0.1% led by unfavorable fluctuations (-3.6% YoY) in foreign currency exchange rates; offset by organic service revenue growth (+1.8% YoY) and the favorable impact of acquisitions/divestitures (+1.7% YoY).

Source: IRM Form 10-Q 1Q2019

Storage Net Operating Income (NOI) increased by 0.5% YoY from $524.9 million to $527.8 million. Storage NOI / Sq. Ft declined to $6.01 from $6.22 in 1Q 2018.

Adjusted EBITDA saw a downtick of 5.4% from $343.0 million to $324.5 million mainly on the back of rising SG&A expenses (+0.3% YoY), where higher labor costs in the shred business and new global operations support team increased general & administration by 11% YoY. Further, information technology expenses surged 16.9% on the back of information security costs and investments in innovation and product development. IRM reported Adjusted EBITDA margin of 30.8% compared to 32.9% in 1Q 2018.

Income from Continuing Operations plunged 33.2% YoY to $30.5 million or $0.1 on a fully diluted basis, compared with $45.6 million or $0.16 on a fully diluted basis in the same period previous year, primarily due to increased operating and interest expenses, as well as an increase in the provision for income taxes.

Consequently, FFO decreased by 9.6% YoY, from $152.1 million to $137.5 million, due to the factors impacting Net income/EPS, precluding real estate depreciation and data center Lease-Based Intangible Asset Amortization. Further, AFFO declined by 12.7% from $221.5 million to $193.4 million.

Source: IRM Form 10-Q 1Q2019

Despite a general slowdown in the RIM business segment and lower net profits, IRM paid a dividend per share of $0.61 compared to $0.59 in 1Q 2018.

Outlook

Despite weak first quarter 2019 results, particularly on the EBITDA front, IRM has maintained its full year guidance noting strong recovery in the back half of the year on strong growth in data center business coupled with cost initiatives. While revenues are expected to grow at 1.8%, adjusted EBITDA and EPS are expected to grow at a higher rate of 2.7%, implying cost efficiencies. The more important and relevant REIT metric AFFO is expected to grow at 3.0% to $900 million.

Source: IRM Investor Presentation June 2019

My Take

I’m always wary of when companies shift their business models or strategies – especially if the new business model is too far removed from the company’s current core business. We see it all the time – companies getting rid of non-core businesses – businesses that they probably shouldn’t have gotten into to begin with. 

In the case of IRM, we see an interesting opportunity because although the data center business is different than the document storage business, I could see how the company’s value proposition and capabilities could be extended to data center properties with some slight adjustments. 

The company currently pays out an 8% dividend yield and we also see upside potential in the stock. We see the price closer to $38 based on a price/AFFO multiple of 12x on AFFO of $3.05. In 2020, we see even more potential as AFFO should ramp up to $3.23-$3.26. 

We rate the stock a Buy and I will be adding it to my portfolio. 

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in IRM over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.