Description

Thesis

Public Storage (PSA) is the largest owner and operator of self-storage facilities in the U.S. Though PSA’s shares have fallen from $110 a year ago to $71, they are still richly valued in view of the following:

1. Priced at 15x trailing cash flow and 2.5x tangible book value, PSA shares are expensive considering likely declining cash flow over the coming quarters due to high fixed costs, higher marketing expenditures, declining occupancy rates and declining rental rates.

2. The self-storage industry is saturated: there is a 19 ft.² closet for each household in the U.S.

3. PSA’s industry features low entry barriers, high exit barriers and few scale economies.

4. B. Wayne Hughes, PSA founder and chairman, sold 3.1 million shares PSA shares since 8/24/09 at an average price of $70.60. Mr. Hughes has reduced his stake in PSA by 67% since 12/10/08 (the Hughes family collectively, including B. Wayne Hughes’ sales, have sold 20% of their PSA shares in the last 10 months).

Valuation & Capital Structure

The following table shows PSA’s current valuation and capital structure.

Note that PSA’s capital structure includes Series A shares which are entitled to 1/5 of a vote per share and common shares which are entitled to 1 vote per share.  The Series A shares also receive annual distributions equal to lesser of 5x the common share distribution (currently $2.20) or $2.45 per share. 

PSA is unique in the public storage industry in that its capital structure features no net debt. Instead of debt, PSA management uses preferred shares which yield about 7% at par. Unlike debt, the preferred shares are permanent capital, an advantage PSA advocates are quick to point out.  PSA management increased its 2008 earnings by purchasing $101 million of its preferred shares for $67 million, thus contributing $34 million to 2008 earnings. While PSA is not alone in taking advantage of its own deteriorating prospects by arbitraging its capital structure, this is not sustainable and is probably not what PSA investors had in mind when buying PSA shares.

Cost structure, occupancy and rental rates

Like many real estate businesses, PSA’s cost structure is almost entirely fixed. As a result, small changes in revenue and costs, e.g., lower occupancy rates or higher use of promotions, lead to large swings in cash flow. PSA management indicated on their most recent investor call (as did the managers of its publicly-traded competitors) that they will increase their one variable cost, marketing expenditures, during 2009 in an effort to maintain occupancy and rental rates.

While PSA has experienced a decline in occupancy rates before, and in fact occupancy rates have fallen for the last three years, falling rental rates is a new development. In fact, industry practice has been to consistently raise rates at regular intervals.  PSA’s U.S. same-store revenue was slightly positive for 2008. European same store revenue was down 2.3% year-on-year during Q4 2008 on a constant exchange rate basis.  PSA management thinks European revenue will decline further on a same-store basis this year.

According to Dean Jernigan, U-Store-It’s CEO, discretionary customers are thought to represent 10 to 15% of the self-storage market. While this may seem insignificant, it becomes important when one considers the high fixed cost nature of this business, i.e., small changes in revenue result in large changes in cash flow.  Furthermore, one may conclude that self-storage demand is a symptom of consumerism gone wild, i.e., self-storage is for those whose acquisitiveness exceeds their closet space. To the extent this is the case, one would expect self-storage demand to fall as consumption expenditures are trimmed.

Self-storage bulls make the case that the self-storage industry is recession resistant because demand is event driven, e.g., marriage, divorce, graduation, military assignment, natural disasters and moving.  In fact, moving is the most commonly cited event driving self-storage use.  One article we read theorized that people use self-storage when selling their home so that the house appears less cluttered to potential buyers. Regardless of the reason, industry participants believe that home sales drive self-storage use.

The velocity of homes sales was likely driven by easy credit conditions and a housing bubble, and taking into account the current economic conditions and our conclusion that these conditions will persist for several years, there is no reason to conclude that home sales are likely to return to 2005 levels in the foreseeable future. By itself, lower home sales probably pose a headwind to PSA, but there are other pressures, outlined below, which are likely to reduce PSA’s cash flow in coming years.

Saturated

The U.S. is saturated with self-storage.  How can we make such a claim? Consider the data in the following table (from the Census Bureau and the Self-Storage Industry Fact sheet):

Self-storage growth since 1984

Note that, on a per capita basis, self-storage has grown 5.5x over the last 24 years.  There is now enough self-storage capacity to provide every household in the U.S. with a 19 square foot closet.  In fact, at 6.9 square feet per capita, there is enough capacity to cover all 306 million Americans provided we are all standing. Data published by the Self-Storage Association, an industry advocacy group, indicates that markets are oversupplied as they broach 7 square feet of capacity per capita. We may already have more than 7 square feet per capita: the Self-Storage Association’s fact sheet indicates that there were 7.2 square feet per capita as of mid-2008.  Even PSA has acknowledged the glut and added only 1.6% to its U.S. capacity in the last three years while industry capacity increased by 37%. This is likely to be a contributing factor to PSA’s falling occupancy rates during the last three years.

Poor competitive dynamics

The self-storage industry features poor competitive dynamics, e.g., low barriers to entry, high barriers to exit, lack of scale economies.  For instance, the primary barrier to entry is zoning, which is not formidable.  High traffic locations are desirable for self-storage facilities, but facilities may be built anywhere local authorities permit.  There is a movement to re-purpose abandoned box-stores and industrial sites into self-storage facilities and an entire industry devoted to helping individuals buy and build new self-storage facilities.

As a result, self-storage facilities multiply like rabbits: there are now 52,753 self-storage facilities in the U.S and ninety percent of all self-storage companies own and operate just one facility. During one twelve-month stretch spanning 2004-05, 8,694 self-storage facilities were built (16.5% of today’s total U.S. capacity). To say this industry is fragmented is an understatement, and there is evidence that it is becoming more fragmented.  For instance, data from PSA’s 10-Ks indicate that the four publicly traded self-storage companies had an 11% market share in 2008, down from a 17% share the previous year.  This fragmentation is important in light of how self-storage companies compete: given the high fixed cost structure of self-storage facilities and the heterogeneous nature of the industry, one would expect promotions and discounting to become irrational as marginal players are squeezed by lower occupancy rates.  There is evidence that this is happening.  Considering that 90% of the self-storage companies own one facility, one may expect those companies to have very high exit barriers, i.e., it many cases it will be the owner-operator’s primary source of income.

PSA and its other large competitors claim that they enjoy scale economies and cite their ability to share the cost of yellow page advertising and Internet search terms over a number of facilities. The evidence, however, is that there is very little in the way of economies of scale.  First, note  the industry fragmentation after decades of consolidation efforts by the large players. Second, consider the industry’s cost structure as shown in the following table:

PSA’s cash costs: 92% of costs are fixed

Marketing and promotion represents only 8% of the cash costs of running self-storage facilities.  Direct property payroll, general and administrative and maintenance costs represent 50% of the cash costs of running a self-storage facility – these are costs that an owner-operator may consider as salary. There is, however, at least one source of scale economies that the large players enjoy: cheap sources of finance.  It is likely that the large players are able to raise debt and equity financing, at least historically, on better terms than one-store competitors. This, however, is a reason not to be a passive investor in self-storage, i.e., the suppliers of the finance are the patsies at this table. If you think it is an exaggeration to call PSA’s investors patsies, note that Ronald Havener, PSA’s CEO, was paid a $16 million bonus for his efforts in 2008 to sell 51% of their European operation to a third party (substantially more than he was paid to run the company!).   

We conclude that the rapid growth of the self-storage industry over the last decade is most likely a symptom of the same easy credit policies which brought us the Internet / telecom bubble and, more recently, the housing bubble. As credit continues to contract, we expect self-storage demand to decline at the margin as competitors cut prices to maintain occupancy. Given the high fixed-cost nature of this business, small reductions in revenue will result in large reductions in cash flow, which is likely to depress valuations of PSA and its competitors.  While PSA’s balance sheet is clearly the best in the industry and its operating metrics are superior to its competitors, it is valued over 40% of replacement cost.  Given the competitive dynamics in the industry, the problems of PSA’s competitors are likely to depress PSA’s cash flow as companies cut prices to maintain occupancy.  Paradoxically, PSA’s high occupancy rates make it even more suitable for shorting, i.e., there is no room for improving occupancy rates. 

Self-storage background

The self-storage industry started in Texas during the 1960s when pre-fab garages were erected on the outskirts of towns and rented-out to locals. Today there are 52,753 self-storage facilities in the U.S. The five largest self-storage companies, PSA, EXR, SSS, YSI and UHAL own and operate 4,620 facilities, with the remaining 48,133 facilities owned and operated by 31,400 companies (averaging 1.5 facilities per company). The mean revenue per self-storage facility in the U.S. was $423,530 during 2007 averaging $10.33 gross annual rent per square foot. Storage lockers typically range in size from 5’x5’ to 10’x30’ with 10’ to 12’ ceilings.  Lockers are rented on a month-to-month basis; typical rental periods are eight to fourteen months; promotions often include one-month free rent.  The highest turnover of rental spaces happens during April, May and June. Over the last decade, the strategy employed by the big four was to systematically raise rates while cutting expenses; as discussed above, the competitive dynamics of the industry are now pushing companies to reduce rates for the first time in memory. Typically, 70-75% of self-storage customers are consumers, the balance being commercial users.   Fifty-five percent of customers are male, 26% live within one mile, 52% live within two miles and 80% of self-storage customers live within five miles of the facility they rent. The median income of self-storage customers is $45,000.  The largest customer segment has annual income of $20,000 to $30,000 and the second largest segment has income below $20,000. The two main reasons given by consumers for using self-storage are lack of adequate storage space at home and need for storage while moving.  The three most cited reasons by commercial customers are: 1) inventory; 2) excess supplies and furniture; 3) business records. 

Catalyst

Declining business fundamentals as self-storage companies compete to maintain occupancy.