Equity Issuances Threaten To Undermine Iron Mountain's Growth Story

Summary

• IRM posted highly impressive growth numbers in Q2.
• However, the company's common equity issuances nearly offset the growth numbers entirely.
• Given that the equity capital was reinvested at accretive rates of return, the long-term growth trajectory remains intact.
• In the meantime, however, IRM will be challenged to simultaneously maintain dividend growth and make progress on its payout ratio and leverage reduction goals.

Iron Mountain (NYSE:IRM) once again proved in Q2 that its well-known and highly trusted name-brand and global network of decades-old relationships with many of the world's top companies is driving strong operating performance and growth. The downside from the quarter is that IRM's free cash flow deficit, high dividend payout, elevated leverage, and aggressive growth aspirations continue to require management to issue new equity, diluting FFO/share growth. While IRM's operational stability, attractive dividend, and growth runway make it an attractive investment for income seekers, total shareholder returns may be subdued until management can reduce reliance on equity issuance and improve the company's speculative credit rating and negative credit rating outlook.

Safety

The company's moat appeared to remain as strong as ever during Q2 as Adj. EBITDA margin expanded 130 basis points and the business continued to experience strong growth. While these are very encouraging signs and imply that an investment in IRM should remain very safe for the foreseeable future, there do remain items of concern as indicated by the speculative credit rating and negative credit outlook. Primarily, through aggressive acquisitions into the data center space to fuel its growth, IRM has taken on considerable leverage. While management pointed to its average leverage positioning within the REIT sector, the reality is that its leverage is considerably higher than its nearest peers in the self storage and data center segments (blended 4.3x-5.1x leverage vs. 5.6x leverage for IRM). Moody's has implied that it wants to see IRM move its leverage into this range as well and IRM hopes to reduce its leverage into that range by the end of 2020.

Source

Due to this high leverage and the ongoing heavy CapEx requirements to develop and integrate its data center business, management is having to issue considerable amounts of common equity to make up for the capital shortfall without further aggravating leverage since cash flows leftover after maintenance CapEx and dividends account for only ~13% of the incremental capital needed for growth investments/CapEx. This has led to an 8.2% year-over-year increase in the shares outstanding. Combined with the 6.8% year-over-year dividend/share hike, the company's total dividend payout has climbed an enormous ~15.6%. With an already elevated payout ratio, this puts enormous pressure on growth projects to deliver significant accretive returns. Meanwhile, they will have to continue managing their debt maturity profile and refinance loans as rates rise. This will also put additional strain on the payout ratio and debt servicing metrics.

Growth

The good news is that the company's AFFO grew by 16.3% year-over-year in the first half of 2018, outpacing the growth in the dividend payout. This growth should only continue to accelerate as the company recycles equity it raises at a 6-7% cost of capital (the dividend yield at the time of sale) into projects with cash yields several hundred basis points higher. Furthermore, these projects have pretty compelling growth prospects (due to margin expansion and economies of scale as well as growing demand for data center services) that are much higher than the low to mid single digit annual pace that IRM is likely to raise its dividend at moving forward.

Given that IRM's CEO claims to "pray for inflation every single day", the current inflationary environment should bode well for the company's ability to grow its way out of its leverage and payout ratio crunch by helping to offset rising interest rates and declining internal storage volume. In the first half, IRM's internal storage business did just that: with revenues growing 2.1% despite 1% volume declines. The company's business model also continues to be received well in emerging markets with 7.7% internal storage rental revenue growth.

Valuation

Management projects being able to maintain a 4% annual dividend growth rate through 2020 while it also reduces its leverage ratio to 5x. This seems a bit optimistic and will require ongoing robust growth in emerging markets, data centers, and shredding services, and stable revenues in the paper storage business. Inflation seems to be accelerating, and if it continues it should add an additional tailwind to reaching this objective. With the yield currently around 6.55% and the projected dividend growth rate at 4%, IRM appears poised to achieve ~10.5% annualized returns over the next several years.

IRM data by YCharts

However, given the factors contributing to the speculative credit rating (BB-) and negative outlook, I think it is wise to apply a significant factor of safety to this projection since IRM will find it challenging to simultaneously maintain dividend growth and reduce leverage significantly. I therefore apply a 0.8 factor of safety to this projected return, reducing my risk-adjusted projected return to ~8.5%, making it roughly fairly valued and a hold at present.

Investor Takeaway

IRM's moat remains strong, combining with inflation to drive growth across the company. However, heavy equity issuance is keeping the payout ratio elevated which in turn makes it more challenging for IRM to generate excess funds to reduce further equity issuance needs and reduce leverage. Management has an ambitious plan to grow the company out of its leverage crunch while simultaneously maintaining solid dividend growth. If they can execute, IRM is poised to deliver outsized returns to investors by combining an attractive yield with above-average REIT growth. Given the challenging numbers, however, investors would be prudent to apply a significant factor of safety in estimating their returns on this investment, making it a hold at present. Income investors, however, should view this as a highly stable 6.5% yield and therefore will likely find it an attractive addition to their portfolios.

Analyst’s Disclosure: I am/we are long IRM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.