Description

CUMULATIVE PREFERRED SHARES

I believe the preferreds of Public Storage (PSA) are mispriced because REIT preferreds are generally perceived as low quality, junior securities in an industry that has a high level business and capital structure risk whereas PSA preferreds are actually the senior debt of what has been called the Berkshire Hathaway of REITs.

PSA is the largest owner and operator of self-storage facilities in the United States.   PSA operates 2,000+ storage facilities in 38 states and has an equity interest in 181 facilities in Europe operating under the Shurgard Storage Centers brand name.  The company has shut down its development activities in the US and Europe and per the 10-K has "increased its yield requirements with respect to acquisitions of existing facilities."  In 2007, 2008 and Q1 2009 (run rate), PSA generated approximately $1bn of operating cash flow (after deducting maintenance CAPEX which is effectively $0).  PSA only pays out approximately $600mm of the $1bn to shareholders leaving $400mm/year for debt retirement, a regular and continuing activity. 

PSA has 18 series of Cumulative Preferred stock outstanding with a combined liquidation preference of $3.4bn.  These $25 par issues have coupons ranging from 6.125% - 7.5% and are trading at discounts to par with yields between 8% (PSA+I) and 8.4% (PSA+C or E) depending on the liquidity of the issue.   As is typical, PSA cannot pay any common dividends unless these preferreds are fully current.

The investment idea is to buy any of these series of preferreds to achieve a 23% 12 month return (8.4% annual yield plus 15% capital appreciation assuming these issues trade back up to a 7.25% yield) with virtually no principal risk.

Capital Structure:  PSA uniquely uses these perpetual preferreds (Rated BBB+) as the senior part of its capital structure which consists of:

Position                                                                                                                $000 at 3/31/09

Senior Secured

                5.47% avg rate mortgages (1/2011 - 8/2015)                                             $234,078

Senior Unsecured

                5.875% senior note due 3/2013                                                                $186,460

                5.730% senior note due 2/2011                                                                $106,697

                                Total senior                                                                           $527,235 (offset by cash)

Cumulative Preferred Shares                                                                                   $3,399,777

Book Equity (without preferred shares)                                                                     $5,476,114

(Market Value Equity)                                                                                           $11,200,000

There is a relatively small amount of senior secured and senior unsecured debt above the preferreds; however, this $527,235 is more than offset by cash of $493,400 and a loan receivable from PSA's equity JV in Shurgard Europe of $517,497.  Even if we assume the Shurgard Europe loan is impaired (which there is currently no reason to do), there is still plenty of cash to cover the senior obligations.  As shown in the table above, PSA faces no debt maturities until 2011 which will easily be handled by internally generated cash flow.

Furthermore, the equity holders are valuing the shares at more than twice book value and are willing to accept a 3.4% dividend yield (paltry in REIT land) for the privilege of owning shares.

Cash flow:  PSA generated over $1bn of operating cash flow in 2007 and 2008 and $259mm in Q1 2009.  PSA's CAPX was $76mm in 2008 and $8.5mm in Q1 2009.  During Q1 2009, PSA repurchased preferred stock of $170.5mm and recorded a gain of $78.2 million to net income.  PSA also bought back $110.2 million of debt, realizing a $4.1 million gain.

Excellent Management:   Acknowledged as having one of the best management teams in the industry.  Management has actively been buying non-cumulative preferreds lower in the capital structure than the cumulative issues recommended in this write-up.

Business Risk:   In the self-storage space, PSA owns among the highest-quality assets supported by the top platform in the business.  Occupancy remains strong at 88%, but there is some pressure here as move-outs occur at a higher rate than move-ins.  As a sector, storage REITS perform relatively well in difficult occupancy environments due to lack of required tenant improvements and the costs associated with releasing space.  And, in the worst case scenario, PSA has more than ample cash flow to either hunker down or to buy distressed assets from competitors.

Target Price and Yield:  So what should a PSA BBB+ perpetual preferred be priced to yield?  Well the Moody's corporate BAA index is currently yielding 7.93%.  This includes many issues that will become fallen angels due to deteriorating economic conditions.  Since PSA preferreds are BBB+ or better they should command a premium to that index and my 7.25% target yield is likely conservative.  A  7.25% yield is also consistent with the BAA historical average 220 bp spread over a 10 year governments assuming a normalized 5% 10-year. 

Catalyst

Catalysts:  (1) Get paid while you wait for appreciation, (2) continued contraction in BAA spreads which are still 560 bps over the 10-year government versus the 220 bp historical average - see above if you are concerned about spreads compressing because of rising 10-year....