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Iron Mountain (NYSE:IRM)

Q1 2013 Earnings Call

May 01, 2013 8:30 am ET

Executives

Melissa Marsden

William L. Meaney - Chief Executive Officer, President and Director

Brian P. McKeon - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Analysts

Kevin D. McVeigh - Macquarie Research

George K. Tong - Piper Jaffray Companies, Research Division

Andrew J. Wittmann - Robert W. Baird & Co. Incorporated, Research Division

Gary E. Bisbee - Barclays Capital, Research Division

Steven Shui - Stifel, Nicolaus & Co., Inc., Research Division

Andrew C. Steinerman - JP Morgan Chase & Co, Research Division

Operator

Good morning. My name is Bonnie, and I will be your conference operator today. At this time, I would like to welcome everyone to the Iron Mountain First Quarter 2013 Earnings Call Webcast. [Operator Instructions] Thank you. I would now like to turn the conference over to Ms. Melissa Marsden. Please go ahead, ma'am.

Melissa Marsden

Thank you, Bonnie, and welcome, everyone to our first quarter 2013 earnings conference call. I'm Melissa Marsden, Senior Vice President of Investor Relations for the company.

This morning, we'll hear from Bill Meaney, our CEO, who will discuss highlights and strategic initiatives; followed by Brian McKeon, our CFO, who will cover financial results. After their prepared remarks, we'll open up the phones for Q&A.

Per our custom, we have a user-controlled slide presentation at the Investor Relations page of our website at www.ironmountain.com.

Referring now to Slide 2. Today's earnings call and slide presentation will contain a number of forward-looking statements, most notably our outlook for 2013 financial performance. All forward-looking statements are subject to risks and uncertainties. Please refer to today's press release, the Safe Harbor language on this slide and our most recently filed Annual Report on Form 10-K for a discussion of the major risk factors that could cause our actual results to differ from those in our forward-looking statements.

In addition, we use several non-GAAP measures when presenting our financial results. The reconciliations of these non-GAAP measures, as required by Reg G, can be found at the Investor Relations page of our website, as well as in today's press release.

With that, I'd like to turn the call over to Bill Meaney.

William L. Meaney

Thanks, Melissa, and thank you to everyone for joining us today. We're off to a good start in 2013 with first quarter financial results in line with our expectations. Total revenues were $747 million, adjusted OIBDA was $227 million and adjusted earnings per share was $0.27 per share.

Operating performance also is tracking in line with our full year ranges with consistent storage rental constant dollar growth of 4.4% and storage rental internal growth of 3%.

As noted in recent quarters, we continued to see a decrease in activity-based services. These trends continue, but we are able to offset these impacts to deliver solid profit results.

I'll turn it over to Brian to cover the details of our results in a few minutes. But first, I'd like to talk about what we're seeing in our markets and some of the ways in which we plan to sustain the durability of our core business.

Since our last report to you, we've continued to make progress on many fronts and have integrated our strategic review into the budget process for 2014. More specifically, some of the areas of focus include: preparing to operate as a REIT; continue to emphasize organic growth, both in the mature and emerging markets; expanding through acquisitions which are accretive and which meet our strategic and financial hurdles; and evaluating close-in adjacencies.

With respect to the REIT, we are moving forward with plans to build on our solid foundation and enhance our strategy. As we've said before, we can't comment on the specifics of our PLR, or Private Letter Ruling. We can say that in general, the process can take about a year, but we don't control the timing. As you know, we filed our PLR in mid-July 2012 and we continue to prepare for conversion moving full steam ahead with systems upgrades and the legal and tax restructuring necessary to move some of our International businesses into QRS. We have accomplished much, but there's more work to do.

Additionally, we continue to advance our thinking about real estate investment opportunities and how we present the attractive characteristics of our business that align well with other REITs.

As we've said previously, we have very high rental revenue per square foot and the quality and durability of our storage net operating income is exceptional, with extremely low volatility across business cycles. We also have a high credit quality customer base characterized by strong retention and relatively low maintenance and turnover costs. We believe these characteristics will continue to support the solid fundamentals of our business and will be of interest to investors seeking both attractive current and total shareholder returns.

Turning now to operations. We continued to see good growth opportunities in both our developed and emerging markets. By developed, I'm referring not only to our North American markets of Canada and the U.S., but also to Australia, Singapore, the U.K., as well as Western Europe, where our business continues to perform well despite financial market uncertainty and challenging macroeconomic conditions.

There are several ways we look to sustain the durability of the business in our developed markets. One is by enhancing our industry-specific expertise in vertical markets and adding value for customers through tailored solutions around Records Management and demonstrating how our solutions address their requirements, whether they are regulatory, commercial or operational in nature.

Another is by differentiating our core storage and service offerings with innovative tools that drive incremental storage from existing customers and attract new customers. We are encouraged by early visibility into our pipeline of booked business and active pursuits. This pipeline is slightly more skewed towards new customer relationships, demonstrating the potential in the unvended or partially unvended market.

Generally speaking, there is a long lead time between sizable new bookings and implementation, so we expect very little of this new business pipeline to be reflected in our 2013 results.

On our last call, I mentioned the realignment of our sales and marketing teams to focus on vertical market opportunities. It's early days, but we're making progress. We pioneered this focus in the health care vertical and achieved a storage volume increase of 2% year-over-year in the first quarter in North America. The growth from our higher margin storage rental revenues is offsetting expected pressures from lower margin services, impacted by shifts towards electronic medical records.

Given the storage margins are more than 2x that of service, this shift in the health care vertical has led to an overall increase in profit contribution. Additionally, we are receiving great feedback from customers who view us as their source for insight into industry best practices. We have expanded forums such as the customer advisory board and industry symposiums to bring top customers together to discuss challenges and opportunities. Based on insight from our financial services advisory board, 2 subcommittees have already been formed to help shape future products and services.

Another example of our vertical market focus is the federal government. While not a significant part of our business today, we believe there is a sizable opportunity tied to the 2012 Presidential Directive on Records Management. This directive facilitates federal agencies in better using records to assess the impact of programs, reduce redundant efforts, save money and share knowledge within and across their organizations. We recently cosponsored a study that found federal government records are expected to grow from 8.5 billion to more than 20 billion records over the next 2 years. Whilst the bulk of the new federal records are being created electronically, 41% of those documents ultimately are printed and managed in paper format, underscoring the durability of growth in the physical record storage.

Our penetration of this vertical segment is progressing slowly, but we recently completed a deal to store 250,000 cubic feet of veterans claims records with potential to add document management services. What we're finding is the federal government has historically awarded contracts to small systems integrators that don't always have the capability or the full know-how to service the business once they get it. We're seeing real opportunities to partner with these smaller integrators in order to establish our foothold in this vertical segment. Moreover, we continue to be confident that the federal government will increasingly need to outsource Records Management with the private sector, given their fiscal constraints.

In addition to our vertical market approach, we are advancing our go-to-market approach to help differentiate our core storage and service offerings and as a means to tap the unvended market. We've identified multiple unique customer types, ranging from the pure physical storage outsourcer to the workflow digitizer seeking to convert all physical records to digital and several variations in between. By customizing our approach, we can better map our solutions to each type of customer, integrating more consultative services.

An example of an offering for the sophisticated customer looking to unify records is our Accutrac solution, which enables organizations to centralize the management of both physical and electronic records, helping them find records faster and lower risks of noncompliance, as well as cutting storage costs.

Let me now turn to emerging market opportunities. By emerging, I'm referring to the BRIC countries, as well as other Latin American countries like Chile, Argentina, Central and Eastern Europe, countries like Turkey, the Czech Republic and Poland, as well as other Asia Pacific markets, such as Hong Kong. Our emerging markets currently represent about a $300 million business for us and we have significant opportunities to expand our platform in these fast-growing countries through both acquisitions and organic growth, positioning ourselves to capture the first wave of outsourcing.

In the aggregate, these emerging markets achieved storage rental constant dollar revenue growth of 30% in the first quarter or 17% when excluding our recent acquisition of Grupo Store in Brazil last year.

Moreover, we have a solid pipeline of potential acquisition candidates in emerging markets. Many of these deals would accelerate the growth of our business into leadership positions, which as we've noted in the past, is a driver of incremental margin improvement in our International markets.

As we've noted, many of these emerging markets are early in their process of outsourcing records management. We have opportunities to enhance our growth in emerging markets by leveraging the solution-based product and service offerings we originated and refined in our developed markets, where we've been in operation for much longer and implementing those programs in our emerging markets.

By helping customers early in the outsourcing process to become more efficient and reduce costs, we will become a trusted partner and ultimately drive more business.

We are also continuously evaluating close-in adjacent businesses that support our core Records Management business and meet our return hurdles, and we will continue to evaluate these opportunities through ROE, cash flow and return on invested capital filters. We have recently announced our plans to move forward with expansion of the underground wholesale data center in Pennsylvania that we talked about at Investor Day last October. Again, it is early in the process but we are encouraged by initial customer demand, and we will prudently evaluate the opportunity through this initial effort before undertaking incremental investment. Part of our investigation will include looking at the feasibility of above ground wholesale data centers on existing Iron Mountain land. We believe we can continue to deliver sustainable value and support business growth by targeting 25% to 35% of our free cash flow for investment in emerging markets, acquisitions and adjacencies. We believe this level of investment would be similar under our existing structure or as a REIT, and is consistent with our capital allocation approach through which we also maximize cash flow, generate strong returns and maintain significant payouts to our stockholders.

To wrap up, we have a great business with good momentum, supported by a strategy to sustain our growth over the long term.

And with that, I'll turn it over to Brian to discuss our financial results in more detail.

Brian P. McKeon

Thanks, Bill. Let's turn now to Slide 3 which highlights the key messages from today's review. We delivered good operating results in Q1, driven by a consistent storage rental growth which supported solid profit performance. Overall growth trends were consistent. Storage rental growth grew 4.4% on a constant dollar basis in the quarter, supported by 2% gains in North America and 12% growth in International, including benefits from our 2012 acquisitions in Brazil and Europe.

While storage growth remains solid, we saw similar declines in query-based core service activity leading to lower retrievable refile and transportation revenues in mature markets.

Service growth declines were a bit higher in Q1, as expected, reflecting some tougher comparisons in International markets, as well as declines in storage destruction and termination fees. We expect these impacts to moderate as we work through the year.

Adjusted OIBDA was up 2% and on-track with our full year outlook. Our profit results continue to be supported by International margin gains and sustained cost controls. Overall, Q1 was in line with our expectation, supported by solid storage growth, strong International gains and continued efficiencies in capital investment.

Today, we're reiterating our full year 2013 performance outlook. In addition to our revenue and profit performance, our capital expenditures and free cash flow generation are all tracking to plan.

Let's move on to Slide 4 to review our financial results in more detail. Slide 4 compares our results for this quarter to the first quarter of 2012. As noted, Q1 results were as expected, supported by solid storage rental growth. Enterprise revenues grew 0.5% on a constant dollar basis, as our International segment continued to produce strong revenue performance. International posted 7% constant dollar revenue growth, supported by 12% storage rental growth, including benefits from our acquisitions in Brazil and Switzerland.

North America posted minus 2% constant currency revenue growth, as lower service revenues more than offset consistent 2% storage rental gains.

Year-on-year changes in recycled paper prices and FX rates had minimal impact in the quarter.

Gross profit was $426 million in Q1, yielding a gross margin of 57%, down 80 basis points compared to the same prior year period. Storage gross margins increased 40 basis points, reflecting good cost management with growing revenues. Service gross margins were down year-over-year due to decreased revenues from the lower core service activities. Mix impacts from 2012 acquisitions was also a contributing factor.

Adjusted OIBDA was $227 million, up 2% year-on-year. Adjusted OIBDA margins improved to 30.5% of revenues in Q1, driven by lower SG&A expense, excluding REIT costs.

Our underlying profit performance continues to improve in our International segment, consistent with our plans. International adjusted OIBDA margins increased 100 basis points in Q1, as we remain on-track to achieve 25% margins in 2013.

Savings from the North American sales and account management realignment and lower stock option compensation expense were also contributing factors to the year-on-year increase in adjusted OIBDA.

Adjusted EPS for the quarter was $0.27 per share compared to $0.29 in Q1 2012. The decrease was due to the higher number of shares outstanding following the issuance of 17 million new shares last November as part of our special dividend.

Adjusted OIBDA and adjusted EPS exclude the impact of costs associated with the REIT conversion. These costs reduced Q1 2013 reported EPS by $0.09 per share net of tax.

GAAP earnings per share of $0.10 includes $25 million of REIT costs and $3 million of other expense, partially offset by $1 million of gains on asset dispositions. Our structural tax rate for the quarter was 38%.

Let's now take a closer look at our revenue growth on Slide 5. Slide 5 shows the components building to our overall revenue growth. Q1 growth rates were in line with our expectation and our -- with our expectations and our full year outlook. In terms of components building to overall growth, storage rental internal growth was 2.5% for the quarter, service internal growth was minus 6.5% and total revenue internal growth was minus 1.4%. Acquisitions and FX changes combined to add 1.4% to our reported results.

Overall, our durable storage rental business provides a solid foundation for our overall revenue performance. For the quarter, consistent storage rental growth of 4.4% on a constant dollar basis supported total constant dollar revenue growth of 0.5%.

Year-on-year global net volume growth was 2.8%, including about 1.1% benefit related to the store acquisition in Brazil.

North America reported 2% constant dollar storage rental growth, reflecting relatively flat Records Management volume and consistent pricing trends. International storage rental growth was 12% constant dollar for the quarter, reflecting sustained double-digit growth in Latin America, Central and Eastern Europe and Asia Pac.

For the year, we expect overall storage rental to sustain consistent growth rates of about 4% on a constant dollar basis and about 3% on an internal basis.

Total services decreased 5% constant dollar as expected headwinds in activity-based services continued, and we faced some tougher near-term comparisons in International. These impacts more than offset solid DMS growth and benefits from our 2012 acquisitions.

The International segment posted 1% service growth supported by acquisitions, DMS growth and higher project revenues, which more than offset lower shredding revenues due to some customer terminations in early 2012. We've now lapped those terminations and should have better comps as we move forward through the balance of the year.

Overall, North American service revenues declined 7% in the quarter with about 4% of that decline related to activity-based core services. Gains in DMS revenues were offset by lower revenues from special projects and ancillary service lines, including entertainment and fulfillment services.

Paper prices had limited impact in Q1 as sorted office paper pricing has stabilized recently in the $150 to $160 per ton range. Assuming stable recycled paper prices, we expect to see improvement in our service revenue growth rates as we work through the year, supported by gains in our International segments and from increases in DMS revenues as we continue to build this business.

Let's take a look at our segment performance on Slide 6. Slide 6 shows key metrics for each of our 3 segments comparing Q1 of this year to Q1 2012. Consistent with our business strategy, we're sustaining high returns in our North America segment while we continue to build our International segment as a significant driver of profit and cash flow gains. North America continues to deliver high profits and strong cash flows. For Q1, our North American business segment reported revenues of $542 million, supported by consistent 2% constant dollar storage rental gains. We sustained adjusted OIBDA margins of 41%, as savings from our recent sales and account management realignment offset a decrease in gross profits due to lower service revenues.

We're also sustaining capital efficiencies with spending at 4.4% of revenues, excluding real estate.

Our International segment continues to post strong constant dollar revenue, adjusted OIBDA and cash flow gains. Adjusted OIBDA increased 10% on a constant dollar basis, benefiting from cost improvement initiatives in Western European markets and strong profit performance in Asia Pac. International adjusted OIBDA margins expanded about 100 basis points.

Benefits from productivity initiatives and from continued solid growth across our International portfolio have us on-track towards our goal of about 25% margins in 2013.

Finally, corporate expenses were down compared to prior year levels, reflecting benefits from overhead cost controls and lower stock option expense.

Overall, we continued to drive solid operating performance across our portfolio consistent with our performance.

Let's now take a look at our debt statistics on Slide 7. Strong consistent cash flow generation enables us to maintain a sound balance sheet. Currently, we're operating with a consolidated leverage ratio of 3.95x at the high end of our targeted 3x to 4x leverage range. Our leverage ratio has increased over the past 2-plus years as planned to support cash shareholder payouts of $1.6 billion and expenditures in connection with our proposed conversion to a REIT over that period.

As we've stated previously, the cost associated with REIT conversion, including tax payments, will temporarily and modestly push our leverage over the high end of our target range.

We're well-positioned in terms of cash and financing capacity. At quarter end, liquidity was more than $800 million with $230 million in cash and $612 million in additional borrowing capacity. Our strong cash flow support continued advancement of our capital allocation strategy and our REIT conversion. During the first quarter, we paid $52 million in cash dividends and $31 million of REIT costs, including $6 million of REIT-related CapEx.

We're managing our balance sheet consistent with our strategy, while advancing substantial payouts to shareholders and we remain well-positioned to fund our business plan.

That concludes our review of the Q1 2013 results. Overall, this was a good quarter in which we continued to drive solid financial performance, supported by storage rental gains and position ourselves to achieve our full year 2013 financial goals.

Let's now turn to Slide 8 to review our 2013 outlook.

Slide 8 summarizes our current 2013 operating outlook. Today, we're reiterating our full year 2013 guidance. Our Q1 performance was as expected and consistent with our full year outlook. We expect to sustain consistent storage rental growth and to see improvement in our service revenue growth rates through the balance of the year.

As we've been highlighting, we anticipate significant one-time operating and capital costs associated with our potential conversion to a REIT. These costs relate to substantial system investments, legal and tax work, advisory fees and other miscellaneous costs to implement the proposed structure.

Total operating expense and capital costs are estimated to be between $150 million and $200 million, with the majority of these costs to be incurred in 2013. We're investing to ensure that we meet the January 1, 2014 deadline including having our REIT-critical systems operating on a test basis by the third quarter of this year.

For 2013, we expect to incur between $65 million and $95 million of incremental expense, between $30 million and $45 million of CapEx and to pay $105 million to $115 million in additional taxes related to the depreciation recapture in connection with the REIT conversion. The impact of these items will be a reduction of reported EPS of $0.26 to $0.36 per share and a use of cash of $185 million to $230 million.

We'll continue to track and report these costs discretely from our underlying operating results. Slides laying out our outlook for line items below adjusted OIBDA, as well as the REIT-related items are included in the Appendix.

That concludes our review. In summary, Q1 was a quarter of good financial performance and we're well-positioned to achieve our 2013 financial goals. We continue to execute against our business plans, sustaining high profits and cash flow in North America and driving strong growth and higher returns in our International business. We continue to advance work in connection with the REIT conversion as part of our long-term approach to enhance value creation for stockholders.

Thank you, we'd now be happy to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Kevin McVeigh of Macquarie.

Kevin D. McVeigh - Macquarie Research

Bill, I'd love to kind of get your thoughts, your first quarter out of the gate, any upside surprises, downside? It's kind of interesting it -- you really get a sense of the durability of the business model within all the additional responsibility in terms of managing through the REIT conversion process. So just any thoughts on that initially would be helpful.

William L. Meaney

Kevin, I think not really any big surprise. We're tracking as planned. I think the only thing that coming is from an outsider coming in, it's always good to see that even though Europe is not doing well from a macroeconomic standpoint -- if you look at the mature markets in Western Europe, is we continued to have solid, physical growth in terms of the -- in terms of storage rental. So we're still tracking quite well even in the mature markets. And then, emerging markets, we're continuing to find more and more upside. So I've been spending quite a bit of my time internationally over the last month or so, and we do have real opportunities there and it's starting to show in our results. So no real surprises, I think we're pretty much within expectations. But it's nice to see that things are tracking ahead.

Kevin D. McVeigh - Macquarie Research

Great. And then Brian, it looks like we're able to update kind of the REIT-related and other expenditures out through kind of '14 to '16. And I know we can't comment on the PLR, but any sense of what gave us the confidence to do that. Just within the context of the PLR overall would be helpful.

Brian P. McKeon

Well, I think we've said all along that going through this process, we felt we had good arguments on the key issue areas that we need to resolution in the PLR and it's not certain. That's why we need to get feedback from the IRS, but we feel confident in our arguments and made the decision to move forward with the investments, because we need to, given the scope and complexity of our conversion effort to make sure that we're on track for the January 1 conversions. So the estimates that we provided, Kevin, are consistent with what we've highlighted in the past. I think we're just giving you some clarity on how that's playing out in terms of the phasing in 2013. But it's the same range we've been highlighting.

Kevin D. McVeigh - Macquarie Research

No, no, no, I know that. I guess, I thought the '14 to '16, that incremental data was new. It looked like the '13 range was consistent, but I hadn't seen the '14 to '16 so I didn't know if that was something that -- just what drove the decision to provide that.

Brian P. McKeon

I think it's consistent with what we've been sharing so...

William L. Meaney

Yes, Kevin. If we had put that out previously and it's really more to do with like the timing of tax payments, primarily that drags it out to '16. There are a couple of conversions that would likely take place past 12/31/13 which are also in that column, but we've put that out before.

Brian P. McKeon

It's all consistent with the same plan we've been outlining.

Operator

Our next question comes from George Tong of Piper Jaffray.

George K. Tong - Piper Jaffray Companies, Research Division

I just wanted to get some additional color around your progress in converting your systems to be REIT-compliant by the end of this year and to begin operating as a REIT by the beginning of next year. Could you discuss your progress there? And how you expect the rollout to progress as we move forward?

Brian P. McKeon

Sure, no. We again are targeting to be ready for the election on January 1. And to be positioned to do that, we have to align our legal entities internationally and we have the initial countries that we're converting, which is the U.S. and several other countries and need to have all our information systems aligned so that we can measure performance in qualified REIT subsidiaries, taxable REIT subsidiaries, and ensure that we're complying with the key requirements like the asset test. So we're -- to do that effectively, we're touching a lot of our ERP systems. We have more than one in our company. We've used different versions in International operations. We're in the midst of the heavy lifting of all of that and preparing for kind of a transition over in -- this summer so that we can test this well in advance of the January 1 conversion. And I would say, there's a ton of work going on. We're obviously investing a lot behind that, but everything is on-track, and we feel good about the progress that we're making there.

George K. Tong - Piper Jaffray Companies, Research Division

That's very helpful. And then, as a follow-up question, could you discuss the dynamics in your various International markets as it relates to storage growth? And any opportunities you're seeing in specific countries and strategies you have to increase the performance of some of the markets that you may not be a leader in currently?

William L. Meaney

Well, I think that -- thanks, George. I think, let's kind of divide the International between 2 groups, so the emerging and the mature markets. On the mature side, I think we continue to see some opportunity for tuck-in acquisitions. But even absent of that, we have seen consistently over a number of quarters now is solid -- not just solid revenue growth around storage, but also solid cube growth. So absolutely showing that where people are storing more and more paper and tapes with us during that period. So that's good to see and that's both in countries where we have already established our market-leading position and those of countries where we are not in a market-leading position. And in mature markets, obviously, we have to be more thoughtful in terms of looking at acquisitions that truly complement our current operations and build in terms of our franchise. In the emerging markets, we have, first of all, very strong fundamental underlying growth. But there's also, in a number of countries, we've already established our market-leading position, like Chile, but we're also finding other countries where there's good acquisition opportunities to continue to build on those franchises. And as I say, the underlining franchise themselves are showing very high physical storage growth and revenue growth. In addition, in a number of the emerging markets, specifically around Latin America, we're finding a lot of growth around BPM, or Business Process Management. And that many cases leads us to have even a stickier relationship with a number of our customers. In fact, the number of our customers start with more -- with our work around BPM or managing some of their paper processes and then it leads to storage, rather than the other way around. But as I say, it strengthens our relationship with those customers and we're showing good growth both on the Business Process Management, whilst it has a lower margin, but it has a very high return on invested capital and as I say, and continued strong underlying growth in the physical storage business.

Operator

Our next question comes from Andrew Wittmann of Baird.

Andrew J. Wittmann - Robert W. Baird & Co. Incorporated, Research Division

I wanted to just dig in a little bit on your comments, Bill, on M&A. It sounds like you're looking at a lot of stuff right now. I think previously, we were thinking about the company over kind of like a 10-year period and thinking $100 million a year was kind of the right way to think about what capital allocation to M&A could be. Is that, in the near term, maybe elevated from that level based on what you're seeing out there today?

William L. Meaney

It's hard to comment at this point. We're pretty -- we're very disciplined in terms of our acquisition process. And right now, we're not constrained by capital, but we are seeing more and more opportunities and, as I say, International expansion is an important part of our strategy. We did, as you know, a fairly large acquisition last year in Brazil. We continue to see acquisitions in our pipeline. I think you can expect that we'll continue on that trend. To say what our total appetite is in terms of expenditure around that at this point, it's hard to say, but I wouldn't change our guidance at this stage. But we are aggressively looking at what makes sense from an acquisition standpoint and we will continue to do that. But as I said, it was a very clear view in terms of what our hurdle rates are in terms of return.

Andrew J. Wittmann - Robert W. Baird & Co. Incorporated, Research Division

Got it. And just in terms of managing the balance sheet, maybe Brian on this, you're going to poke a little bit above the targeted level. How comfortable are you about going -- or how high would you go and for how long would you go if the right deal came around above that kind of targeted range?

Brian P. McKeon

Yes, that's a good question. I mean, as a company, we've operated above 5x leverage. I'm not saying that that's what we'd be targeting to do. But I mean, I think our business has a lot of capacity to support higher leverage. I think we would look at it in the context of the opportunity. We'd likely perhaps move more towards the 5x range if we needed to temporarily. But I think we'd look at different alternatives and what's the right way to finance the acquisition, too, if we get something more significant. But our longer-term goals are the same. The intent would be to manage our leverage back down towards the 3x to 4x target range. And we feel quite comfortable with the business that we have, that we can both manage the short term and get back to where we're hoping to be over the long term.

Andrew J. Wittmann - Robert W. Baird & Co. Incorporated, Research Division

And maybe just one more, kind of on this theme. Bill, you kind of talked about you're exploring wholesale data centers on existing land. I think strategically, it makes some sense from a high level, just given your focus on data management and outsourcing key data protection services. But obviously, you're clearly a technically more complex business in terms of what the building actually is and there are specialized developers and owners of that real estate today. As you look at potentially getting into that business, is this something you think you have the skill set in-house? Or is this an area that you think you'd have to kind of bring in a platform to do that?

William L. Meaney

A good question. Well, first of all, I think we start getting into this business because our customers asked us to start providing services. So as you know, we're already providing wholesale data center service to 7 customers in our underground facility as we sit here today. And it's pretty much along the lines that you're saying is that there is an opportunity to continue to both expand that business and then, when we look at what customers want is our underground facility outside Pittsburgh is more of a disaster recovery site and a number of the customers are also asking for wholesale data center services or retail services that service their day-to-day data processing needs. And those need to be closer to their headquarters or their centers of operation. So there's a link between aboveground and underground facilities. That being said, both because the question you asked and do we have the full skill set in-house and because it is a market where there are a number of competitors, is we're doing it in a very thoughtful way in letting our customers lead us into these arrangements rather than spending a lot of capital upfront and building it and see if they come, if you know what I mean. And we are as part of this process adding the right people at the right spots. But this is not large numbers of people, but it's actually hiring the right senior leadership team to support Mark Kidd, who is actually leading that effort for us, to make sure that we have the right critical skill set that can evaluate the opportunity properly.

Operator

Our next question comes from Gary Bisbee of Barclays.

Gary E. Bisbee - Barclays Capital, Research Division

I wanted to first ask about the color on the pipeline of new business opportunities, in the commentary that you're optimistic and a lot of it is from new customers of the company. We haven't heard a lot of comments in the past around that pipeline. So can you give a little color on where you're seeing opportunities? And is this an acceleration from what the trend has been in recent years? And just what makes you have that positive commentary?

William L. Meaney

I wouldn't say it's an exploding trend. I think that similar to what we said I think -- I believe we said on the last call this verticalization, I think of it as a way of actually taking out the drill bits and doing the hard mining to get to the next level in the vein of resources. So it's similar along the lines of what we say, we're starting to see some what I call the green shoots in the federal market with our win in the veterans area. And we're seeing some green shoots in the health care area, which is the vertical that we've been operating in the longest, and we're getting into some related areas for our traditional health care clients, which is now almost a 1-for-1 set off on a revenue basis of what we were losing on the service side because the medical records becoming electronic. And yet it's at a -- it had more than a 2x margin because we're replacing that business, the service business, around electronic medical records with more physical storage in areas like pathology, but also in terms of other physical records that is a 1-for-1 almost trade-off in terms of revenue, but at more than 2x the margin. So this is a trend where, as I say, is through the verticalization is mining deeper either in our current client relationships or clients that are in that sector but have traditionally not outsourced or completely outsourced their storage business.

Gary E. Bisbee - Barclays Capital, Research Division

And then just following up on that, can you give an example or 2 of how the offerings have changed in health care? Are you doing things different or is it really understanding the pain points for the customer and how to adopt the current offerings to help them relieve their issues?

William L. Meaney

It's a little bit of both. So I mean, one area and a new area which we've started in just the recent months is in the whole pathology area, which was an area that, oddly enough, we were in way back when through an acquisition we did in Boston, our first acquisition in Boston, but it's now a business that we're coming back into. As well, it has a number of areas where they weren't as sensitive to the documentation that they were keeping, either from a compliance standpoint or a space standpoint. So it's more areas where there was less sensitivity in terms of space and or compliance requirements and they now need to have those documents stored in a secure way. And the other side, as I say, is areas like pathology, which people now are realizing that those types of samples need to be stored in a proper way.

Brian P. McKeon

Gary, I'd also highlight that I think the dedicated sales focus in the health care vertical, we had other product offerings. We do DMS-type work, we have our product offering around digital records center for medical imaging. And being in the flow of all the change that's going on in the health care space has enabled our organization to identify opportunities, to do things like grow storage. So I think that part of the concept around the verticalization strategy is having more -- having sales and account management resources that have more specific industry insight. And by being involved with the changes that our customers are going through, we're better able to identify opportunities to do business with them. And that's certainly been the case in health care.

Gary E. Bisbee - Barclays Capital, Research Division

Okay, that make sense. And then, just one last one which is, just what gives you confidence -- in the commentary I heard, a comment I heard a couple of times that you think the service declines will ease as we move through the year. Is it really just a comps issue or is there anything else going on?

William L. Meaney

It's a comp issue in that we knew we were up against, particularly in International, some shredding account losses and we had a DMS account that we're working through. And so we know we'll be up against more favorable compares. But also that we're targeting improved growth in areas like DMS as we work through the year and that will help as well. We just really wanted to highlight that this isn't a change in trend. This is a kind of a consistent underlying trend on activity-based volume. We do have some tougher comps and we expect those numbers to improve.

Operator

Our next question comes from Scott Schneeberger of Oppenheimer.

Unknown Analyst

For Scott. Can you take us a little deeper on the drivers of International margins in the quarter, and if you see any particular dynamic that might enable you to exceed your long-term target there?

William L. Meaney

The key drivers there, we were having good underlying storage growth. In the International business, we had a 12% constant dollar, 5% internal, solid growth across the business. And I think that is a good -- helps everything. It's a high-margin business and helps us to build scales across our business. And we continued to see the flow-through benefits of the improvement plan in Western Europe. If you recall the portfolio review and the productivity improvement plan that we implemented, those benefits to continue to just flow through. We're comfortable that we're on track towards the goal that we outlined in the 2-year plan of the 25% margin growth. This achievement, this year, not signaling any upside to that. And we've indicated over time, we think there is room for additional margin improvement in International but want to temper our expectations there where we think future gains will be more moderate, and that we're really focused on maximizing the value opportunity there. But -- so no change in the expectations, but we feel good about the progress that we're making.

Brian P. McKeon

Yes, and just one thing to add to that, Scott, is remember -- and again, I think we mentioned this last time, you have to look at our International business, because of the growth potential there, as a portfolio. So as countries, for instance, if we take again Chile, which has amongst the highest margins of our operations worldwide, mature or emerging markets, is because if we've got our market-leading position there, there will be other places where we continue to build a market-leading position so it would generally drift those margins up. But we are adding in new areas where we have real opportunity. So it's a portfolio approach of adding less mature opportunities into a group of countries that may be getting more mature. So net-net, you have to -- it's not clear that it would even be the right strategy to say that our average margin would go up internationally because that would signal that we're not finding new markets to actually go into and eventually build a market-leading position. So you have to look at it as a portfolio approach in International. The key in International is to make sure that when we're doing acquisitions, we have a clear discipline in terms of our return on invested capital and return on equity. And we have a clear strategic vision of how that country or that investment will eventually build into a market-leading position.

Operator

Our next question comes from Steven Shui of Stifel.

Steven Shui - Stifel, Nicolaus & Co., Inc., Research Division

You guys had mentioned that the improvement in North American margins are partially due to the realignment of the sales force for the health care vertical. Can you give us a sense of how much North American margins can potentially improve as you guys realign the sales force verticals beyond health care?

William L. Meaney

We had a little trouble hearing you. But -- the end of the question you're saying how much more could North American margins increase?

Steven Shui - Stifel, Nicolaus & Co., Inc., Research Division

Yes, once you realign the sales force beyond health care.

Brian P. McKeon

The sales force realignment that was done last year wasn't just related to health care, it was a broader realignment. And we've been consistently signaling, don't expect margin improvement in North America. I think we've got a very high margin business operation. We're trying to sustain that and be balanced about an appropriate level of investment to ensure we have a healthy and sustained annuity over time. So those efficiencies enabled us to sustain good returns and that's what you should expect for this year.

William L. Meaney

And just to emphasize Brian's comment, the verticalization is about maintaining our consistent storage revenue growth in North America. It's not about margin expansion. There was a one-time benefit of that in terms of the realignment to the sales force that allowed us to be more efficient. But the verticalization is really about to be able to maintain our consistent revenue growth performance around storage in North America.

Steven Shui - Stifel, Nicolaus & Co., Inc., Research Division

Okay. And to change direction, given where paper prices are now at a relatively depressed level compared to last year, have you guys seen any improvement to the pricing environment for Shredding?

Brian P. McKeon

Paper prices have been in a relatively consistent range, $150 to $160 a ton, for several months now. So I think that stability, it's a bit below the longer-term averages, which would be in the $200 a ton range. And I think the Shredding business, we feel good about progress there. But I wouldn't signal that there's any meaningful change in kind of pricing dynamics. It's been a relatively stable environment.

Operator

Our next question comes from Andrew Steinerman of JPMorgan.

Andrew C. Steinerman - JP Morgan Chase & Co, Research Division

Could you go back to internal revenue change in core service, the minus 7 is kind of a larger number relative to last couple of years. Do you feel like the things that have affected the first quarter will meaningfully get better through the year? Or do you feel like this will be a year of larger declines in core service than we've experienced in the past?

Brian P. McKeon

Andrew, we were trending minus 3 to minus 4 internal growth Q3, Q4. If you look back to Q1 of last year, we had growth in core service. So this isn't a fundamental change. I mean, I think we're seeing very consistent kind of pressures on the mature market activity-based services and we would expect to move back towards more kind of the range that we were in the last couple of quarters and with opportunity to improve on that because we have goals that we have in terms of driving project-based revenue and building aspects of our business. So I think it's -- we're trying to signal don't take Q1 and trend that out in terms of a growth rate that's more reflecting lapping and some specific things. But I think the trends that we saw later last year are probably more indicative of where we'll be heading in the next couple of quarters.

Andrew C. Steinerman - JP Morgan Chase & Co, Research Division

That's helpful, Brian, and one more question on the same subject. You also cited declines in destruction as part of that dynamic in core service. And whenever I hear declines in destruction, I often think that, that should help the storage revenues. Is that dynamic happening or is this a different type of destruction?

Brian P. McKeon

Well, we did see, in terms of the destruction and termination fees, it's not a huge driver of the number in North America, but it was lower in Q1, down double digits. Some of that's timing, so I don't want to indicate like a fundamental change there. But you're right, that is a relatively positive dynamic. I think it's reflective of a lot of the work that we've been doing over the last couple of years on customer retention, customer excellence and the benefits of that. So yes, it should be something that helps us over time. Some of -- to be fair, I mean, some of this is just timing and when things happen. But I think that is a theme that hopefully you are hearing here that we feel quite good about the storage dynamic. I think it's consistent, it's healthy. We're expanding our footprint globally and as that, our International business continues to grow, it has very healthy underlying growth rates. We're feeling good about that as a longer-term trend.

Operator

Our next question comes from Gary Bisbee of Barclays.

Gary E. Bisbee - Barclays Capital, Research Division

Follow up. In thinking about all the investment you're doing in terms of preparing for the REIT, is that fully captured in the one-time cost and charges that you've been giving us that number for the REIT? Or are there some costs through SG&A and cost of sales that might fall off next year as you get through the process? And if so, how significant are those costs?

Brian P. McKeon

It won't fall off, Gary. It will go the other way candidly in the sense that we've been highlighting all along that as our anticipation, as we come through the conversion process, there's a whole bunch of one-time costs. We will have a level of incremental ongoing costs in we've -- our estimate, I believe, has been $10 million to $15 million. If you think about it, we're going to need additional tax resources, some additional financial resources, legal resources to just manage the incremental compliance requirements, things of that nature. We do anticipate that over time, we should get efficiencies as well out of this effort and that we're standardizing a lot of our systems and our approaches. I think that's going to take a little time to flow through because our focus really here is to make sure we're getting to the goal line on the right -- as quickly as we can and to make sure we don't miss that. But I wouldn't expect or I don't want to signal that we're going to see like a drop off in underlying costs. We really tried to be clear about segregating these costs and they're separate from our ongoing operational costs.

Operator

At this time, there are no further questions.

William L. Meaney

Thank you, operator. To wrap up, we're off to a good start in 2013. Our durable growth in storage rental continues, we have attractive opportunities to sustain that growth through acquisitions and further expansion into emerging markets, as well as investment in our adjacent businesses -- opportunities. We are on track to deliver against our financial goals. We're making good progress on preparations for our planned conversion to a REIT and we have an attractive storage rental business with durable, high-quality net operating income that aligns well with REITs.

As we continue to execute against our plan, we will be focused on prudent capital allocation, maximizing total returns and delivering sustainable value to our shareholders.

Thank you for joining us this morning.

Operator

Thank you. This concludes today's conference call. You may now disconnect.

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