A Closer Look at Iron Mountain's High Yield

Iron Mountain's (IRM) stock price has declined 16% since peaking in late November 2017, worse than the S&P 500 (down 1%) and the broader REIT index (down about 9%).

Last quarter IRM's price fell so low during the market's correction that the stock's dividend yield rose to a record 8%, which is a level high enough that some investors worry whether or not the market is signaling the dividend is unsafe.

Let's take a closer look at Iron Mountain's recent performance, and evaluate whether or not the payout is safe and likely to keep growing.

Why Iron Mountain Struggled in 2018
Obviously 2018 wasn't a banner year for stocks in general. Thanks to the worst December for the S&P 500 since 1931, the market as a whole finished down about 5% for the year, it's worst showing since 2008.

REITs themselves have been struggling in a bear market which was kicked off by long-term interest rates rising from a record low in mid-2016 (the 10-year Treasury yield bottomed at 1.36%).

While long-term rates have fallen in recent months (slowing inflation expectations and a flight to safety from stocks), REITs still lost approximately 6% in 2018, even factoring in the sector's generous dividends.

As for Iron Mountain itself, there are likely two reasons why the stock struggled in recent months.

The first is that investors might be worried about any company with a junk bond credit rating (Iron Mountain's rating is BB-). In recent months the combination of rising interest rates, the recent crash in oil prices, and fears of slowing economic growth has caused investor demand for junk bonds to fall dramatically.

The chart below plots the average yield across all BB-rated debt over the last five years. As you can see, in 2018 the yield on BB-rated debt jumped significantly, rising from under 4.5% in January to nearly 6.5% in December.

As a REIT, Iron Mountain naturally has a highly leveraged balance sheet (more on this in a moment). Should junk bond yields continue to rise or even stay at current levels, then the REIT's future refinancing costs could increase.

The second possible reason for Iron Mountain's recent struggles is some investors' growing concern that the REIT's core business (document storage) is suffering a long-term secular decline as paper files lose share to digital documents.

For example, in late October 2018, analyst firm Stifel downgraded the REIT. The firm said it expects continued declines in Iron Mountain's developed market volume storage going forward, which it believed would limit the stock's upside over the next 12 months.

So with Iron Mountain potentially facing two fundamental challenges (debt and storage volume declines), what does that mean for dividend investors? Is the long-term dividend growth thesis broken?

Reviewing Iron Mountain's Dividend Safety
First, it's worth noting that a major reason why junk bond yields spiked in 2018 is due to fears of another prolonged oil crash. During the oil crash of 2014-2016, when over 100 oil producers went bankrupt, we saw a similar sharp spike in junk bond yields.

Since Iron Mountain's actual business has nothing to do with volatile commodity prices (its cash flow is quite stable and recession resistant), fears that the company may be headed for a debt cliff are largely overblown. In fact, the REIT's bonds have an average duration of 6.3 years and it has no major debt maturing until 2023.

What about worries surrounding Iron Mountain's document storage business, which accounts for 62% of the REIT's revenue and 80% of adjusted gross profit? First, it's important to realize that this segment's outlook is quite different in developed markets (like the U.S. and Europe) than emerging markets.

Over the years Iron Mountain has diversified around the world and is now the planet's largest physical storage provider. Approximately 80% of its storage business is in developed markets, but nearly 20% is in emerging markets.

Over the past six quarters, developed market storage volumes have been declining, turning negative for the last three (early 2017's strong growth was due to a major acquisition).

With temporary currency headwinds offsetting strong price increases this year, the REIT likely recorded flat developed market storage revenue for all of 2018. 

However, it's important to remember two things. First, in developing countries where digital document penetration rates are generally much lower, Iron Mountain's storage volumes are actually growing strongly and even accelerated in recent quarters. The REIT recently made a major acquisition of a Chinese storage firm which is likely to continue that trend. 

What's more, as the REIT's CFO Stuart Brown explained to analysts on the latest conference call, the business is buoyed by dependable destruction-related fees, at least in the short to medium term:

Iron Mountain has been in business for 67 years, so management has a very strong understanding of its core business. Therefore, it's not surprising why the firm is confident that volume declines won't set back its 2020 growth plans.

In fact, the physical storage volume decline rate Iron Mountain is experiencing in developed markets amounts to a rather insignificant $2 million per year decline in revenue. Compared to shredding revenue volume, which totals $15 million, and that headwind seems even more manageable to overcome, assuming trends don't worsen.

To help its long-term outlook, Iron Mountain is also diversifying into faster-growing services such as document shredding and data storage (its cloud computing business). Services now account for nearly 40% of revenue and reported 7% sales growth in the third quarter of 2018.

Data centers (6% of revenue and 8% of adjusted EBITDA) are an especially important driver as they are already contributing about 1% to 2% annual cash flow growth at the company-wide level. Iron Mountain also has a data protection business (another 12% of revenue) that is growing strongly.

Management is leveraging its decades-long connections with clients (95% of the global Fortune 1000) to get companies to transition to its new data security and cloud computing offerings.

The REIT's long-term goals are to transition increasingly into faster-growing emerging markets, services, and data center solutions (nearly tripling capacity in the coming years) to deliver long-term organic EBITDA growth of 5% per year.

By 2020 Iron Mountain's plan calls for data centers to grow to 10% of adjusted EBITDA, and the REIT is already on track to potentially exceed that target.

But more importantly, management expects to achieve 10% to 13% internal rates of return on the firm's data center investments, in line with its traditional document storage business.

Management's goal of generating 30% of revenue from faster-growing businesses is also well on track. Factoring in recent acquisitions, Iron Mountain's "Growth Portfolio" hit 23% of overall sales in the third quarter of 2018.

Meanwhile, the core physical document storage business, which has 98% annual customer retention rates (resulting in its average client leasing storage space for 15 years), continues providing the REIT with stable and predictable cash flow. As a result, Iron Mountain has a reasonable amount of financial flexibility as it continues executing on its long-term growth plans.

As seen below, management is choosing to continue growing the dividend at a stable 4% annual rate through 2020, which is below the rate of targeted adjusted funds from operations (AFFO) growth. Therefore, Iron Mountain's AFFO payout ratio (currently a safe 80%) should move lower over time.

A lower payout ratio will allow the REIT to address its junk bond status over the coming years, reducing its risk profile and improving its dividend safety. Specifically, by 2020 Iron Mountain expects to have a leverage ratio of 5.0 which is below the sector average of 5.6.

And in the long term, the REIT plans to reduce its leverage ratio even further to about 4.75 thanks to a targeted AFFO payout ratio of 73%. That should be sufficient for Iron Mountain to achieve an investment grade credit rating, helping ensure it maintains access to credit markets and addresses the market's current worries about future refinancing of its junk bonds.

Overall, the market's concerns over the death of paper storage feel a little dramatic. Iron Mountain's core document storage business continues to experience modest overall growth thanks largely to its overseas diversification.

Meanwhile, the REIT appears to be on track (actually ahead of schedule) to achieve stronger long-term growth via expanded investments in emerging market storage, storage services, and data centers.

Combined with management's deleveraging efforts and gradual shift to an even more conservative payout ratio, Iron Mountain's dividend appears to remain secure.

Concluding Thoughts
While Iron Mountain's core business generates stable and recession-resistant cash flow, the firm's junk bond credit rating means this isn't a blue-chip REIT today.

And although declines in developed market storage volumes might prove a permanent trend, it's important to note that Iron Mountain is a global REIT, whose emerging market storage business is growing fast enough to offset declines in developed markets. 

This, combined with growth in its data storage business and physical storage services, is why the firm's revenue and cash flow growth remains solid and seems likely to remain so in the future.

Investors will certainly want to watch that management delivers on its long-term goal of deleveraging over time by growing the dividend slower than cash flow. Additionally, it's important that the firm's diversification efforts into faster-growing businesses do not shrink the returns it earns on invested capital. 

For now, Iron Mountain appears on track with its long-term plans, which should result in both a safer payout ratio in the future (while maintaining 4% dividend growth through 2020), as well as eventual upgrades to investment grade debt ratings. 

At the end of the day, Iron Mountain's choppy performance in recent months appears appears to be driven more by noise than news. Broader market weakness, a spike in junk bond yields, and an analyst downgrade (predicated on a 12-month price target that has little to do with the firm's long-term outlook) all contributed but are largely transitory forces.

While Iron Mountain is not for everyone given its junk bond credit rating and evolving business model, it remains one of the more interesting true high-yielding stocks for investors who are comfortable with its risk profile.