Iron Mountain's King of the Hill

Boxes have been the basis of  Iron Mountain's (IRM) cash flow annuity for the better part of six decades, allowing investors the chance to participate in the growth of a stable recurring revenue stream. However, the company's successful pursuit of real estate investment trust status sent a strong signal to the market that earnings reinvestment opportunities are limited and the time had come to milk the cash cow. In the context of a digital world, it is easy to conclude that Iron Mountain's paper-based empire reached its peak long ago. Nevertheless, we don't expect this mountain to erode overnight. Even as a REIT, Iron Mountain's ability to produce rental income is predicated on preserving a stable base of stored boxes as it repositions itself for the realities of a changing business model. Although we acknowledge the competitive difficulties of an industry in secular decline, we believe Iron Mountain's scale-driven cost advantage backs a narrow economic moat that protects long-term value generation for shareholders.

Scale Leads to Major Competitive Advantages
Even as a REIT, Iron Mountain's future rental profits depend on keeping its warehouses filled with boxes. With nearly 500 million cubic feet of records housed in more than 67 million square feet of worldwide warehouse space, Iron Mountain's industry-leading scale is the main competitive advantage that underpins our narrow Morningstar Economic Moat Rating. Iron Mountain built its storage business by capturing physical records from nearly 95% of the Fortune 500. These large, multinational companies in pursuit of global expansion left behind a fairly lengthy paper trail that Iron Mountain happily housed, typically for decades at a time. The company's unparalleled dominance in the sheer volume of stored records would be extremely difficult and costly to replicate, in our view.

We believe Iron Mountain commands about 40% of the existing $7 billion worldwide records management market, with other sizable publicly traded and privately held players representing about 30%. Because there are few structural or financial barriers to entry, numerous fragmented players make up the rest of the industry. Iron Mountain's closest competitor, Australia-based Recall Records Management, had less than one third of Iron Mountain's revenue at the end of 2013 and represents only 12% of the existing market.

At its core, profitability in the records management business is driven by volume growth. Once storage infrastructure is in place, it costs very little to store each incremental box, creating an environment that exhibits a high degree of operating leverage. As such, we believe Iron Mountain has derived a cost advantage from its sizable scale, providing the company with better ability to manage per-unit operating costs and sustain outsize profitability per box relative to competitors. In our opinion, Iron Mountain's ability to spread operating costs over a wider base creates a strong defense against competitors attempting to scale. Increasing operating density by winning new boxes often requires additional selling, general, and administrative expense investment, potentially causing cost per cube to climb during periods of higher growth. This phenomenon may explain the differences in profitability between Iron Mountain and fragmented competitors.  

Operating Density Can Protect Returns Even During Secular Declines
Iron Mountain's REIT controls a significant portion of real estate geared toward the protection of physical records. As the most entrenched player in this specialized category by far, Iron Mountain's cost advantage should support its narrow economic moat even as paper record production wanes. While this appears to be counterintuitive, we believe that the nature of this niche storage category, combined with the rapid digitization of global enterprise, will naturally constrain the growth of the future addressable market. This is likely to increase the cost of competition among fragmented players investing more resources to battle for share of a contracting industry. As such, we expect this phenomenon to eventually limit the number of new entrants that could scale quickly enough to produce adequate returns on invested capital. As smaller players struggle to amass volume, a shakeout could result in further industry consolidation.

In our view, Iron Mountain's long-standing relationships with enterprise-level customers have two major advantages relative to fragmented players. The first advantage--and one that we believe the Street is quick to overlook--is what Iron Mountain often refers to as the inertia of the box. A box at rest tends to remain at rest, and it would take a powerful catalyst to move a mountain of boxes. Iron Mountain estimates that the average box stays with it for 15 years, with its warehouses containing a veritable backbone of corporate memory from the time before digital production methods were widely used. The company's real estate portfolio essentially acts as a centralized archive for enterprise-level organizations, a much more efficient method than relying on numerous mom-and-pop storage shops on a piecemeal basis.

Over time, we expect that a handful of entrenched, long-standing stewards of corporate memory will effectively serve the outstanding need for physical document storage. Even though paper use has declined over the past decade, revenue still flows predictably from this resting base of boxes thanks to Iron Mountain's enviable 98% customer retention rate. Unless the majority of the Fortune 500 goes on a massive housekeeping binge, this dynamic should sustain Iron Mountain's capacity for generating rental income as a REIT.

Market's Slowly Shrinking, However
We expect that Iron Mountain's moat source will naturally weaken as the production of paper records--along with the corresponding need for storage--marches toward obsolescence. If demand collapses, fierce competition among the remaining players will probably cause industry returns to deteriorate. Furthermore, cost advantage can only protect returns for so long when faced with an inability to increase price in a weakened demand environment. Iron Mountain may struggle to find tenants or increase rents should the need for physical record storage disappear over time.

Iron Mountain's North American operating segment, which contributes nearly 70% of the company's overall revenue and profitability, is showing signs of secular decline. Over the past five years, the segment produced a tepid revenue compound annual growth rate of just over 1%, along with only a 3% CAGR in adjusted operating income before depreciation and amortization. Just barely positive, these CAGRs mask negative trends in year-over-year volume growth over the past several quarters. Excluding acquisitions, new volume has struggled to replace the aging volume leaving the system in North America, although this negative trend has decelerated in recent quarters.

​

In the past, existing customers produced a steady stream of new volume every year as every business function produced a paper record. However, this rate of volume growth, which the company defines as organic, has been steadily declining. Furthermore, the spread between organic volume and outperms--or volume taken out of storage--is actually widening. This illustrates an important ongoing problem: On average, existing customers are not replacing volume that ages out of the system. Even though outperms have decreased slightly over the past several quarters, organic volume growth continues to decelerate. This negative trend forces Iron Mountain to make up the difference by winning or acquiring new customers, which requires additional resources to be spent in search of volume replacement. Over the past three quarters, acquisitions were actually the main driver of positive net volume growth. In our opinion, this dynamic fully illustrates the challenging secular trend facing Iron Mountain.

We believe it is more important for investors to focus not on the reality that this trend is occurring, but rather on what tools Iron Mountain has available to slow its progression. We don't mean to imply that Iron Mountain has already lost the battle; rather, we suggest that the company's narrow economic moat still has the power to produce positive returns on invested capital for at least 10 years, by leveraging its competitive advantages to extract rents from customers with a need for physical storage.

Pockets of Demand for Physical Record Storage Exist
As Iron Mountain's main income-producing activity transitions from charging customers storage fees as a C-corporation to collecting rent as a REIT, maintaining a stable box base as the principal of a cash flow annuity is still paramount. However, with organic volume growth in its most mature market persistently falling short of replacing outperms, Iron Mountain needs to demonstrate that it can preserve or even modestly expand this principal in an industry facing secular headwinds. This is no small feat, but we believe Iron Mountain is well positioned to take advantage of several opportunities.

In his seminal work Competitive Strategy, Michael Porter contends that industries in decline exhibit structural characteristics, expressed by five key forces, that limit the opportunity for market participants to generate excess returns. However, companies that adapt to meet the pockets of demand that tend to emerge during secular declines can still generate attractive returns. This classic theory meshes well with our belief that scale advantages supporting Iron Mountain's narrow economic moat will help the company shoulder the additional costs of acquiring or attracting new volume as industry competition intensifies.

Because the wide availability of sophisticated imaging technology makes the falsification of digital files much easier than altering physical records, demand is likely to linger in highly regulated industries that keep original documents as a form of proof. These records are classified as archival in nature and remain largely unreferenced while in storage. In contrast, frequently queried records have been increasingly replaced by digital files in the modern-day enterprise. This distinction partially explains why Iron Mountain's service revenue, which includes query-based retrievals, has declined relative to storage revenues over the past five years.

Because of a greater degree of variable costs in retrieving and delivering physical records, service revenue carries lower margins. As such, an ongoing mix shift may actually enhance longer-term profitability if service revenue declines are consistently offset by new archival business. To achieve this, Iron Mountain has been more aggressive in targeting pockets of demand in finance, law, health care, and government through a reorganized vertical sales strategy with the intent of better understanding the specific archival needs of each sector. In addition, Iron Mountain's $200 million acquisition of Cornerstone Records Management in 2013 increased the company's exposure to middle-market customers, a segment that was historically neglected in pursuit of larger customers. Since implementation of these newly defined targets, volume growth driven by new account sales has shown improvement.

However, organic volume growth has worsened, suggesting an ongoing need to monitor existing customer relationships. In an attempt to reverse this trend, current customers that house less than 20% of their records with Iron Mountain have been redefined as "prospects." Near-term organic volume growth should improve if this targeting is successful. Nevertheless, Iron Mountain estimates that this increased focus on verticals, the middle market, and existing customers represents an additional 500 million cubic feet of physical records of domestic opportunity.

​

When analyzing the likelihood of capturing additional volume, risk remains that prospective customers will leapfrog paper record storage altogether in favor of electronic methods. This ultimately widens the competitive landscape to include not only physical storage companies, but technology providers as well. Technology presents a serious and credible threat against the growth of Iron Mountain's future rental income.

Nevertheless, we're not convinced that enterprise-level digital conversion of archival records represents a compelling return on investment, ultimately limiting technology as the most practical substitute. In our view, maintaining records as proof is akin to insurance; customers are apt to pay an insurance premium to avoid the hassle and expense of storing mountains of paper documents while retaining the ability to quickly access them if needed. In contrast, paying a technology provider to implement a comprehensive electronic archival system can amount to a significant up-front capital outlay and may require ongoing upgrade, maintenance, or software subscription expenses. For infrequently accessed records, the cost/benefit of a large-scale digital conversion may not always be justified. In our opinion, this dynamic applies when analyzing Iron Mountain's growth potential in both North America and emerging markets.

Growing Appetite for Outsourcing in Emerging Markets Could Help
We see an opportunity for Iron Mountain to expand internationally, especially in emerging markets with a greater number of self-managed record-keeping systems. As the appetite for outsourcing gains traction in growing economies, we believe Iron Mountain's ability to cost-effectively establish a presence by leveraging its global scale, through either acquisition or contract expansions with existing multinational customers, secures a valuable head start in responding to increased levels of demand. Nearly 70% of an estimated $20 billion addressable worldwide market is self-managed; this suggests ample opportunity for Iron Mountain to extract rents from a growing box base in new markets.

At present, Iron Mountain's international revenue represents less than one third of the consolidated total; however, over the past decade, international sales growth has consistently outpaced the corporate average, with the international revenue CAGR at around 15%, nearly triple the magnitude of North America's revenue CAGR. Adding international volume achieves positive net volume growth globally, even when excluding the impact of acquisitions.

Acquisitions Necessary Component of Future Rental Income Growth
We expect that the slow but steady persistence of box erosion in the mature North American business will create an ongoing need for Iron Mountain to find volume elsewhere; however, prior management teams were criticized for dilutive overexpansion by entering high-growth international markets, where Iron Mountain struggled to achieve significant scale. For example, OIBDA margins in these highly competitive markets averaged low to mid-single digits, with ROICs averaging 1%. Buying volume for the sake of slowing core business erosion is not always a moat-enhancing activity. That said, we believe international M&A still has the potential to offset North American volume attrition while establishing platforms for profitable expansion.

Provided that Iron Mountain avoids the temptation to overpay for market leaders, we believe the opportunities to fortify the company's narrow economic moat by scaling international operations outweigh the increased risk of acquisition-driven growth. To further illustrate, Iron Mountain's operationally dense North American business produces storage gross margins that average nearly 70%, supporting our belief that scale begets operating density, which ultimately leads to superior storage economics. As such, a disciplined M&A strategy targeting local market leaders gives Iron Mountain the chance to quickly enter a region with favorable future outsourcing dynamics at scale, leading to greater operating density over time as sales momentum builds. Furthermore, opportunities to supplement an existing platform with tuck-in acquisitions often present themselves in fragmented markets. While preparing to become a REIT, Iron Mountain culled its portfolio of high-growth but low-return regions in favor of refocusing on areas with better potential for scale. Since the beginning of 2012, these efforts have led to nearly 400 basis points of international OIBDA margin expansion--improvements that we believe are sustainable, especially as operating density continues to build in these markets.

REIT Returns Are Attractive, but Longer-Term Value Remains With Moat
As a REIT, Iron Mountain is worth $36 per share, in our opinion. Over the course of our five-year forecast period, we expect that Iron Mountain can sustain a modest top-line revenue CAGR of 4% through successful execution of the domestic and international growth strategies we've outlined. Assuming that these efforts continue to support the cost advantage derived by Iron Mountain's industry-leading scale, we believe operating profitability can achieve growth of nearly 6% per year on average. Assuming a new effective tax rate of 17%, our projections estimate that Iron Mountain will save approximately $70 million in 2013 taxes as a REIT relative to our assumptions pre-REIT conversion. The tax rate may yet decline as more of Iron Mountain's international operations convert to qualified REIT subsidiaries, but we don't expect it to change materially over the course of our explicit forecast period.

We expect that a lower tax rate will immediately enhance Iron Mountain's returns on invested capital. However, we don't believe that this newly tax-advantaged status qualifies as a moat source in its own right. Rather, our narrow moat rating for Iron Mountain remains firmly rooted in the fundamentals of the company's core storage business, ultimately supporting the generation of rental income from a stable or growing box base. While the increased tax efficiency supports a generous boost in dividends for existing shareholders and increases economic profit, this surplus cash flow may yet be competed away, should industry dynamics worsen over time.

That said, we believe the cost advantage Iron Mountain has developed in its core storage business represents a durable moat source capable of withstanding the challenges of an industry in secular decline. Though Iron Mountain is in search of the growth opportunities we've outlined, we believe this competitive advantage will continue to preserve the company's ability to extract profitable rental income from its base of boxes, ultimately transferring the value of the company's narrow economic moat to its new operating structure as a REIT.