At its core, Iron Mountain (NYSE: IRM) is a secure storage company, with operations in both physical and digital spaces. Historically, storage has been a fairly reliable business, but the future here is going to cost a lot of money to build. Here are some things to think about before buying this real estate investment trust (REIT).
The old and the new
Iron Mountain is probably best known for offering safe storage options for physical objects, from old paperwork (historically its core business) to art. This business has been a very stable one over time, since companies don't usually want to go through the hassle of collecting boxes of old documents so they can be moved to a new facility, even if it would save a few bucks. To put some numbers on that, the REIT has a 98% retention rate, and the average length of storage for a box of documents is around 15 years.
However, the world is quickly shifting toward digital documents. Iron Mountain isn't sticking its head in the sand on this issue and, instead, is doing something to ensure the long-term future of its business. In this case, it's opening digital storage facilities, better known as data centers.
This is a material, growing business sector with a lot of competition. The REIT has grown to 15 data centers over the past five years and has plans for continued growth. That said, its business is still skewed heavily toward physical storage, which makes up around 73% of storage revenues compared to roughly 22% for digital storage. Storage is two-thirds of the company's top line.
The rest of Iron Mountain's business (34%) is made up of services that it provides to customers, from shredding old documents to data management. However, roughly two-thirds of its service revenue is related to physical storage. In other words, this business, too, is facing risks from a more digital future.
But, overall, Iron Mountain appears to be doing the right thing by using its cash cow business (physical storage) to fund the shift into a new, similar business (digital storage). The problem is that building data centers is a costly effort, and the REIT has a material amount of leverage. Its debt-to-equity ratio is a huge 7.7 times, which is much higher than most REITs. For comparison, Digital Realty (NYSE: DLR), one of the largest data center players, has a debt-to-equity ratio of 0.8 times, while there's really no comparison point for the company's physical storage business.
Leverage constrains a company's options in good times and can be even more problematic in hard times. This sets up the big risk here. Iron Mountain looks like it's making the right directional shift with its business and has a material amount of growth ahead of it. In fact, the REIT has enough development in the works or on the drawing board to double its digital storage capacity. On top of that, it recently inked a deal with an Indian company that will add even more growth opportunities in the digital space. The problem is funding all of that opportunity.
In late 2020, the company sold some physical storage assets in a sale-leaseback transaction. This allowed Iron Mountain to raise cash for future investment, but it's now on the hook for lease payments on properties it still wants to occupy. Although pitched as a positive, the move kind of flips the script on the REIT concept, changing Iron Mountain from a landlord to a tenant. Sure, the move allowed it to raise cash without taking on more debt, but more conservative investors should probably wonder about the reasons such a decision had to be made.
With a 6.6% dividend yield, some investors will likely take the position that they're being compensated for the elevated leverage and development risks here. That's fair, given that the S&P 500 Index is only offering a 1.5% yield today.
But step back and consider this: Iron Mountain is looking to double the size of its digital business, suggesting that capital investment plans will be elevated for years to come. Finding all the cash it needs will likely become increasingly more difficult since its core physical storage business is likely to be stagnant, or worse shrinking, at the same time. There's a reason why Iron Mountain's yield is close to twice as high as the 3.8% yield on the average REIT, using Vanguard Real Estate Index ETF (NYSE: VNQ) as a proxy.
You have to believe
At the end of the day, Iron Mountain is covering its dividend (the 2020 adjusted funds from operations payout ratio was 80%) and finding ways to fund its business transition plans. But it looks like it is taking fairly aggressive steps to raise the cash it needs so it can avoid adding more leverage to an already debt-heavy balance sheet.
For conservative investors, this probably isn't the best fit. And even for dividend investors with a more aggressive bent, the risk/reward profile here suggests that you'll really need to have faith in management's approach to be a buyer here.