The Problem With Iron Mountain’s Business Model

Real estate investment trust (REIT) Iron Mountain (NYSE: IRM) sports a huge 9.3% dividend yield. That’s pretty enticing when you consider the SPDR S&P 500 ETF (NYSEMKT: SPY) only offers a 1.5% yield. However, don’t jump at the fat yield before you understand exactly what Iron Mountain does, which is actually a little more complex than it seems.

The core of the business

The big-picture theme for Iron Mountain is that it stores important things for businesses and people. Historically, that meant physical records and objects (like art), but the REIT has been moving into digital storage, shifting along with the world around it. Storing things has, over the long term, been a fairly stable business.

Indeed, once a company puts a banker’s box full of paper into one of Iron Mountain’s storage facilities, it tends to stay there for a very long time. Retrieving all those boxes and moving them to another facility would be a terrible effort for what would likely be little in the way of cost savings. To put some numbers on just how sticky Iron Mountain’s physical storage business is, it has a 98% retention rate, and more than 50% of the “boxes” in its facilities stay there for at least 15 years. That’s an annuity-like business.

And it’s using this core, which makes up roughly 70% of its revenues, to build out a digital business. In other words, Iron Mountain is changing with the times, since records are increasingly digital as companies move away from paper. Digital businesses now make up a little more than 20% of the REIT’s revenues, a number that should continue to grow over time.

If you stop here, Iron Mountain sounds like a company heading in a good direction. But there are some issues to consider.

Looking at the negatives

The first problem is that Iron Mountain has a lot of debt. It’s an issue management is well aware of and working to keep in check, with a target leverage ratio of 4.5 to 5.5 times. It’s at the high end of this range right now at 5.3 times, but it’s building out a new business that requires large upfront costs (building data centers) before any revenue shows up. So investors need to keep an eye on debt here.

The second problem is that the dividend may not be quite as secure as investors might like. In the third quarter, Iron Mountain generated funds from operations (FFO), which is like earnings for an industrial company, of $0.61 per share. It paid out $0.6185 per share in dividends. So it paid out more than it earned. A REIT can do that for a little while, but not for very long.

The third problem is a bit more subtle but perhaps more important. While Iron Mountain’s storage business looks very stable, it includes a material service component. At 35% of the top line, services include everything from shredding paper documents to pulling boxes out for review. Its physical business accounts for roughly 70% of its service revenues, or about 25% of its total revenues. Only the company is purposely diversifying outside of physical storage because that business is shrinking, a trend likely to speed up over time. So as the physical storage business declines, there will also be a falloff in service revenues — potentially amplifying the top-line hit.

The offset is the growing data-centered business. However, this is still a relatively new business for Iron Mountain. And, frankly, it’s still pretty new to the world at large. Iron Mountain knows physical storage is annuity-like because of how sticky it is, but it may be too soon to assume data storage is just as reliable.

Not for the risk-averse

Iron Mountain is not a bad REIT and is definitely making solid strategic choices by shifting toward digital storage. However, more conservative long-term investors should probably think twice before jumping aboard. Its core business, helped along by that large service component, could fall off more quickly than expected, and the new digital operation may not be as reliable as investors hope. With the dividend already exceeding FFO, it’s probably prudent to tread with caution here.

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