PSA - Extra Space Storage: No Place To Shelter

2023-08-04 17:37:14 ET

Summary

• Extra Space Storage joined and "won" the bidding war for Life Storage, although an all-stock deal alleviates some leverage concerns.
• Extra Space Storage's shares have fallen to fresh 52-week lows, trading at $125, with elevated interest rates and softer pricing being drivers behind the move.
• The company's second-quarter results show flat funds from operations and lower occupancy rates, with resulting soft pricing leading to a cut in full-year guidance.

In April, I believed that Extra Space Storage Inc. ( EXR ) was looking to add extra space, as it joined the bidding war for its smaller peer Life Storage. Pursuing a deal while the wider self-storage space is seeing a pullback is somewhat of a vague sign, although an all-stock deal should alleviate leverage concerns, with synergies seen as a result of the tie-up.

Being careful on the valuations of the sector, whilst funding costs were on the rise, I was not yet attracted to join the space. Ever since, shares have seen some eventful news, including the closing of the Life Storage deal, as well as the release of softer second quarter results. All things considered, I am not yet pulling the trigger, despite a continued and relentless decline in the share price.

The Base

Founded in 1977, Extra Space Storage is a real estate investment trust, or REIT, that went public in 2004, having grown through a combination of organic growth and dealmaking efforts. The company has grown to operate as many as 2,300 properties by 2022, many owned and operated.

The portfolio measured about 175 million square feet and contained over 1.6 million individual units, or better said garage boxes, with average square footage per unit measuring about 100 feet. Located in many metropolitan areas, the company employed over 4,000 workers, many of which were actually engaged in the actual operations.

The self-storage space has rapidly become a specialized market and niche segment in which Extra Storage Space competes against the likes of Life Storage , CubeSmart ( CUB E ) and Public Storage ( PSA ) . Scale is key here, as the company has many tenants which, unlike for larger industrial properties, have retention rates of just 50% on a two-year basis. This makes the handling relatively labor-intensive, given the modest length and size of the rental contracts, making scale and technology key for efficient operations.

A $12 stock at the time of the IPO in 2004, EXR has been a success as shares hit the $100 mark in 2016 and peaked at $220 by year-end 2021, with strong demand and low interest rates fueling a valuation to about 30 times Funds From Operations ("FFO"). This made me very cautious, as the sector has seen a huge boom during the pandemic, when consumers bought a lot of stuff, while subsequently it has been awarded higher multiples.

This made me fearful about the impact of a reversal of pandemic-related trends, as they could hit demand for the space on top of the the challenge of higher interest rates, certainly a risk given the short-term nature of many of the contracts.

And Now?

Shares of Extra Space Storage fell to the $140s in January of this year, when the market was setting up for some consolidation. In February, competitor Public Storage looked to acquire Life Storage in a deal valued at $11 billion.

Soon thereafter, Extra Space Storage reported a 22% increase in FFO for 2022, with that metric coming in at $8.44 per share, yet the company warned for stagnation with FFO seen flattish between $8.30 and $8.60 per share for 2023.

In April, Extra Space became involved with the biding war for Life, in a deal which would give investors in Life a 35% equity stake in Extra Space Storage, driven by the growth potential as well as possibly up to $100 million in synergies, as the bidding war means that investors in Life are the real winners here.

Even as shares rose to the $160 mark in April, I was cautious. The bidding war for Life and continued elevated interest rates made me cautious, but ever since we have seen shares coming down quite a bit more

As it turns out, shares of Extra Space have now fallen to fresh 52-week lows, trading at $125 at the moment of writing.

More Bad News

In May, Extra Space reported a flattish FFO at $2.02 per share for the first quarter, in fact up a penny on the year before. Total revenues rose by 7.4% to $384 million, driven largely by pricing as occupancy rates of 93.5% were actually down 80 basis points from the year before.

In July, Extra Space announced that the deal with Life Storage closed , as the company reiterated the key metrics at the time of the initial deal announcement.

By August, the company posted FFO of $2.06 per share for the second quarter, flat compared to the year before. Those numbers are a bit misleading of course, as they add back growing depreciation charges which at some point need to be replaced. Looking at the underlying results, we see revenues up just 2.7% to $389 million, and while occupancy rates of 94.2% ticked up from the seasonally softer first quarter, they were down 100 basis points on the year before.

Operating earnings fell by a percent to $273 million, with net earnings falling from $1.73 per share to $1.50 per share, mostly as interest expenses rise rapidly. Interest expenses of $86 million work down to a roughly $350 million run rate based on a $7.5 billion debt load.

Including the contribution of Life Storage, the company did cut the full year guidance, now seeing FFO at a midpoint of $8.25 per share, a twenty cent cut from the previous outlook. This comes as the same store revenue growth assumption has been cut by 1.5% mostly because of lower rates accepted by customers in June and July, likely needed to maintain occupancy rates.

Of course, this is still ahead of the Life Storage deal, with the real impact only seen in the coming quarter, as the results show up in the consolidated results. That said, the regular dividend of $1.62 per share per quarter comes in at roughly 80% of FFO here, leaving very little room to deleverage, all while pricing power is under pressure and interest rates keep rising. In fact, the current dividends surpass the current earnings power, as a current 5.0% dividend yield rapidly is coming under pressure over time, if headwinds continue.

What Now?

The reality is that I am not surprised by the current Extra Space Storage Inc. correction. The lower same store revenue increases are the result of slower economic activity, strong pricing in the more recent past, and perhaps oversupply as well. This hurt the near-term business, but in the long haul, scale is what matters in this real estate category, with many leases being relatively small and of short duration, making efficient handing of tenants key. For that, scale and technology is needed, and that is what the Life deal is set to do.

With Extra Space Storage Inc. still trading at a huge premium to NAV, but moreover debt loads being very high, it remains hard to get upbeat in the near term as more pressure on net interest income is likely seen, even if FFO metrics remain largely stable. This means that shares are now down to the lowest levels since March 2021, although this was a $120 stock in August 2019 already.

While the lower share Extra Space Storage Inc. price improves the appeal, and there are still some long-term drivers in place for the business, it is not the case that the business is insulated from all the long-term trends discussed above. Given this, I am interested to keep a close eye on the shares here, but require a bit more insight to learn the performance in the upcoming quarter results before potentially re-considering this neutral stance.

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