The long road ends
On 6/25/14 the long process, begun in early 2011, for Iron Mountain Inc. (NYSE:IRM) to convert from C Corp status to REIT status was finally resolved by a PLR (Private Letter Ruling) from the IRS granting the conversion request. The happy result of this PLR, at least to those already holding IRM shares, was an after hours surge of 20+% which was validated June 26 on heavy volume of 15,300,000+ shares. This is a company that averages volume of 1,600,000 shares. So is the party over? Are dividend investors going forward, stepping into a potential price downdraft that will destroy their capital? Or is there more upside in IRM to come? I shall endeavor to answer these questions below.
Relevant IRM history to the present
First let's take a step back. How did Iron Mountain successfully get to this point? More importantly, why did they need an IRS Private Letter Ruling to become an REIT?
In late 2010, Elliott Management, an activist investor, took a large position in IRM. Subsequently in early 2011 Elliott Management nominated four individuals to IRM's board, two of whom had REIT conversion experience. Shortly after that, IRM appointed a new CEO and announced plans to pursue REIT conversion. IRM then applied for the PLR to pursue the conversion. A positive Private Letter Ruling from the IRS was needed for a non-REIT to assume REIT status, so that the converting company can prove to the IRS's satisfaction that they meet the requirements to be granted REIT status. There are quite a number of requirements a company must meet and maintain to qualify for REIT status, the three most important for this discussion are:
1) A REIT is a "pass through entity" for tax purposes. That is, the company pays no Federal taxes once the conversion is complete as long as they pay out at least 90% of their income to the shareholders each year. The shareholders then individually pay income tax on that portion of the dividend payment(s) that are taxable. (Some of the dividend may be considered under GAAP accounting rules, ROC (Return Of Capital), which will not be taxable until/if the shares are sold. This tax deferral is a benefit of holding REIT shares, especially for taxpayers in the upper brackets.)
2) A company must invest a minimum of 75% of its assets in real estate and make a minimum of 75% of its gross income from that real estate and/or interest on mortgages.
3) The company must pay out to its shareholders the total of the retained earnings it amassed during its life as a C corporation. IRM can't keep previously retained earnings since that money would give it a great advantage over companies that were REITs from inception and it therefore paid out all their earnings to shareholders.
The initial IRS reaction to IRM's request for a positive PLR from the IRS was not favorable. In June 2012, IRM received an update from the IRS regarding the proposed REIT conversion. In the update the IRS raised questions as to whether the conversion should be allowed. The IRS's potentially unfavorable response contained a real reason and good reasons for a negative PLR.
In reverse order, the good reasons the IRS expressed were:
1) The IRS had formed a new internal group, in governmentese, the "Working Group", tasked to define "real estate" for REIT code provisions and what changes, if any, should be made to the current real estate legal standards.
2) Although IRM's core business, the rental of "rack space" in IRM's buildings, probably qualified for REIT status, just as it does for Digital Realty Trust (NYSE:DLR) for example, IRM offers many services that may not be clearly real estate related, such as fee based document shredding.
The real reason for the negative response may have been a simple fear of a tax deferral epidemic by Washington politicians. The IRS has expressed concern that too many corporations are converting or are planning to convert to REIT status, potentially creating a larger and larger "tax hole."
Whatever the IRS thinking was, the market did not take kindly to the news, selling IRM off sharply both in June 2012 and subsequently each time a positive PLR seemed to be delayed or a negative one about to be issued. Even when IRM showed its commitment to vigorously pursuing a favorable PLR, even if it meant IRM had to make business operation concessions, selling ensued. In October 2012, IRM showed its seriousness in pursuing the conversion, when it declared a special dividend of $4.07 as a partial disbursal of retained earnings. Still, the shares wallowed between $27-$32 as investor opinion on a favorable PLR waxed and waned. The betting seemed to be IRM would not get a favorable PLR or that the concessions for REIT conversion the IRS would demand would cripple its earning/dividend paying ability as an REIT.
Then 6/25/14 the storm clouds cleared. IRM announced a favorable PLR, a further $600-700 million retained earning disbursal in second half 2014 (about $3-$4 on the present 192+ million shares), and an increase in the quarterly dividend from $.27 ($1.08 annually) to $.52-$.54 ($2.08-$2.16 annually). These three developments amounted to the market's equivalent of a winning Trifecta ticket at the track.
Whither goest IRM now
Has the horse left the barn for future dividend income investors?
I don't believe so. First, the dividend is now set to about double going forward as stated above. At $2.08 (the company's lower figure) on the closing price of $35.74, the YOC (Yield On Cost) for dividend income investors will be 5.81%. I, for one, will be adding to my position at $35 or less for a YOC of 5.9-6.5% depending on the buy price. Second, there will be a special dividend in second half of 2014 to distribute the company's remaining retained earnings. This special dividend will be $600-700 million or about $3-$4 on the present 192+ million shares. This dividend is expected by the company to be 80% stock and 20% cash. However the cash/stock in the dividend amount breaks down, the stock price will be adjusted downward on the x-date by $3-$4. No one presently can predict the resultant price on x-date, but it is likely the stock will retreat slightly from present levels as the PLR euphoria wears off and the inevitable profit taking sets in. I would again buy when this happens to achieve my full position if on the x-date and/or on immediately succeeding days the price is $31-35.
As Ben Franklin famously wrote in a 1789 letter, "In this world nothing can be said to be certain, except death & taxes."
Dividend income investors, however have an opportunity to buy IRM with a future YOC of 5.8% or more now. With patience, the opportunity could approach or exceed 6.5% ($2.08/$32) on/after the special dividend x-date. This is a better yield than most REITs of the same investment caliber/dividend outlook as IRM. While timing of the two catalysts of the spike in the dividend and the special dividend will muddy the price water short term, they may well provide the dividend income investor with an opportunity for superior dividend income going forward. As a REIT, IRM will likely not be a short term capital gains stock, but should provide a steady 3-6% dividend yearly income growth. As an additional kicker, the REIT area of data management/document security and disposal is growing rapidly. Digital Realty Trust and Dupont Fabros Technology (NYSE:DFT) are leading REITs in this space. Inevitably there will be consolidation in the space and IRM should be either an acquiree or acquirer at the time that consolidation takes place.
Disclaimer: The information I have provided is not meant to be investment advice, nor is it guaranteed in any way to assure success in IRM or any other stock. Investors need to make their own choices based on further due diligence & their particular investment needs.
Disclosure: The author is long IRM. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.