The Folly of Form over Substance

During every market cycle, fads happen. They become very obvious in hindsight, but the tricky part is recognizing them in real time. My prediction? Some real estate investment trusts that are currently being touted by investment analysts will be trading at the exact same prices five or so years from now (assuming the markets are rationally valued at that time.) Even if the profits grow, the countervailing force of valuation compression will be a nasty offset ensuring mediocre returns.

I’ll give an example. I just finished reviewing a company called Iron Mountain. It is a giant data manager that stores documents, communications, and official records for corporate clients. The investor community loves this stock for three reasons. It is asset light, as the majority of the capital expenditures involve securing data rather than investing in factories and real estate. It is perceived as a very scalable business because corporate clients can be added easily with a low marginal cost. Thirdly, it pays a high dividend and recently converted to a REIT status, and this is currently favorable with income investors (because the interest payments from competing investment opportunities like high-quality bonds have been at historic lows for more than five years.)

These factors have moved the price of the stock from $15 five years ago to $31 today. The decline from $41 in February to $31 today was entirely warranted, although some people have started to consider this a value investment because of the poor year-to-date returns and the seeming attractiveness of the 6% dividend.

The problem? That dividend payment is now 1.5x the amount of money that Iron Mountain is bringing in each year. It is somewhat illusory because it is not the funds from operators that are supporting the payout. It is the funds plus debt issuance (both in the form of borrowing and issuing 3 million shares) that pay a third of the dividend.

And the notion that the company is easily scalable has not been borne out in the numbers despite the regular recitation of that business model by analysts. Iron Mountain made $3.0 billion in revenues in 2008, and makes $3.0 billion in annual revenues now. The high was $3.1 billion in 2011 revenues. When you don’t grow revenues, you have to increase profit per unit (either by raising the costs of services or lowering your own costs) in order to achieve growth.

At Iron Mountain, the profits have only increased from $1.06 to $1.25 over the past five years. The expectation of scalability and impressive growth potential has put a halo effect around the company, but it has been stagnating for the past five years while REIT companies like Ventas, Realty Income, and W.P. Carey have roared ahead.

That brings me to my secondary concern: Iron Mountain carries a lot of debt because it funds growth by borrowing money and has to pay with dividend with partially borrowed money. Of course, most REITs do carry high debt burdens, but Iron Mountain carries an unusually high debt load in an industry known for high debt loads.

It carries $4.7 billion in debt on the balance sheet. The borrowing costs are not low, and the company will pay nearly $300 million in interest expenses servicing the existing debt. It only makes $250 million in profit, meaning the current debt burden eats up nineteen years of current profits. The interest obligations eat up over a year’s worth of profits. This would be potentially tolerable if the company were growing at a fast rate, but revenues have been stagnating throughout America’s economic recovery.

I would imagine that sometime between 2019 and 2021 investors would get an opportunity to buy this stock somewhere in the $30s. I have no prediction on whether the dividend will be cut—a company can grow moderately and borrow in the meantime and still be okay—but I doubt the 2020 payments will be materially higher than the 2015 payments because the company’s long-range plans will need to call for a dividend payout ratio of 75% to 90% to remain on solvent footing.

The debt will act as a drag on profit growth because Iron Mountain is probably close to its maximum borrowing ability, and the profits of the company will only grow from $1.25 to $1.75 over the next five years. The current valuation is 25x the amount of money Iron Mountain generates. If that comes down to 15, as is often the case with REITs during periods of higher interest rates, the price of the stock would be $26 five years from now. If you assume $2 in profits and a valuation of 17x profits, we are talking about a $34 stock five years from now under moderately optimistic scenarios. That is what I mean when I suggest that slow growth, high debt, and a due-to-fall valuation will limit returns in the coming years.

When I think about investing, I try to seek answers in the most fundamental way possible. I can never predict the future with certainty—I can only weigh probabilities and consider acting accordingly. If you have any assiduous sensibilities, it seems that you will prefer buying something like Hershey stock that trades at 21x earnings and grows revenues at 5% per year while growing earnings per share at 10%. The dividend yield is much lower than what Iron Mountain offers right now, but you get growth, a fair valuation, and the likelihood of capital gains in the coming years. But people go to companies like Iron Mountain because it offers triple the dividend yield. I think Iron Mountain’s dividend is a shiny object, and most investors would be better off doing the obvious conservative thing rather than engaging in the speculation that surrounds many companies in the REIT sector that have higher-than-average yields but face the high probability of valuation compression while struggling to grow profits in the coming years.