PSA - Public Storage: Not Storing Here

2023-09-08 05:29:59 ET

Summary

• Public Storage's attempt to acquire Life Storage fell through, leading to a smaller deal with Blackstone.
• The company has benefited from increased adoption and growth in the self-storage industry, as this might level off.
• Public Storage's stock has fluctuated between $270 and $300, with near term concerns about premium valuations and oversupply.

Earlier this year, I believed that Public Storage (PSA) was announcing a huge dividend hike to offset uncertainty on the intended Life Storage deal. The company looked to acquire its smaller peer in an all-stock and hostile perceived deal, making me cautious.

In the end, one of its major peers ran away with the assets, as Public Storage cut a smaller deal with Blackstone over the summer to further grow the business.

While this looks compelling, it is the overall premium valuations (even as shares are down a bit) that prevent me from getting upbeat on Public Storage, and quite frankly the sector at large with higher interest here to stay for a while and some cracks seen in demand.

A Recap

Public Storage was founded in the 1970s, being an owner and operator of millions of garages which are let to more than a million customers in the US. With nationwide coverage, the company is the larger player, competing vs. the likes of Extra Space Storage (EXR) , and being much larger than Life Storage and CubeSmart (CUBE) .

Claiming superior rents and margins, due to greater scale, the company is well positioned to handle the operations involved with the many and tiny rental contracts, with technology allowing for a standardized process.

The industry at large has benefited greatly from increased adoption as about 10% of the US population uses self-storage solutions, up from just 3% in 1990, with inflation and population growth creating additional growth on top of that.

When looking at the business at the start of the year (ahead of the 2022 results) I noted that the company generated $3.4 billion in sales in 2021, up a solid $1.7 billion, due to rental growth and greater demand. Given the intensive nature of the assets - including many tiny rental contracts and the fact that staff needs to be present at sight - the company reported $1.8 billion in expenses, which is a high ratio for a REIT due to the observations before (that of labor-intensive operations). Occupancy rates of 95% were decent, with rents running around $20 per square foot.

The company posted Funds From Operations just over $13 per share, a number set to increase to levels around $15 per share in 2022. The company posted $17.4 billion in assets in 2021 (mostly comprised out of property assets), financed with $9.4 billion in equity.

A $200-$250 stock pre-pandemic saw shares peak around the $400 mark in April 2022, peaking alongside other REIT categories. Notably, higher interest rates and perhaps some concerns about oversupply and lower demand made that shares fell to the $300 mark in 2022.

With 176 million shares trading at $270 at the start of 2023, equity of Public Storage was valued at $47 billion, a huge premium to the $10 billion book value of the equity. This marked a huge $37 billion premium on top of a $17 billion asset valuation, suggesting that the market was valuing this real estate and the operating business around $54 billion! This valued the business at 17-18 times fund from operations as the risk was not necessarily leverage, but mostly valuations, at least in my view.

Trading at $270 in January, shares of Public Storage rose to the $300 mark in February, as the company was willing to acquire Life Storage in an all-stock deal. The business appeared to be hostile as Life Storage initially rejected the deal, which was substantial around $10 billion.

While such a takeover attempt is not unheard of, the company announced a 50% hike in its dividend, paying out $12 per share per annum. Not only did this mark a huge increase in the dividend, the payout ratio was raised to 75% of anticipated FFO, limiting the potential to deleverage.

Given this backdrop, I saw no reason to get involved at around $300 per share in February, certainly not with a potential bidding war on the horizon.

Stuck Here

Since February, shares of Public Storage have traded in a $270-$300 range, now trading just below the lower end of the range at $269 per share. In May the company posted resilient first quarter results with reported revenues up nearly 10% to $848 million, driven by pricing to an important extent, although this weighed on occupancy rates which fell by more than 2 points to 93%. With interest expenses rising modestly following decent management of the debt profile, the company grew FFO to just over $4 per share for the quarter.

As its peer Extra Space Storage emerged as the "winner" for Life Storage, Pure Storage moved on and announced a $2.2 billion deal for Simply Self Storage in July, from Blackstone Real Estate Income Trust (BREIT). The deal involves 127 properties which measure 9 million square feet, with most of these locations located in the faster growing Sunbelt states.

This is a substantial, but really just a bolt-on deal for Public Storage, equal to about 5% of its own enterprise valuation. Later that month, Public Storage priced $2.2 billion in notes in connection to the deal in a 4 tranche deal with a weighted average interest rate of 5.3%.

Slower Growth

Early in August, Public posted its second quarter results as reported revenue growth slowed down to 6% with pricing slowing down, as occupancy rates were still down by 2% to 93% and change. While interest expenses remain relatively flat, the company posted FFO at $4.28 per share, making that FFO for the year is still seen around $16.60 per share.

With dividends trending at $12 per share and net income reported at a similar number (in fact, GAAP earnings of $3.00 per share were exactly the same as dividends), reported book values are no longer growing. Note that these results are of course ahead of the Simply deal, but this is not a game changer of course. So as the company muddles trough and remains reasonably well insulated to higher interest rates (at least for now), shares continue to hover at these levels, but the conclusion from earlier this year remains valid, at least in my view.

A current $47 billion equity valuation, and $53 billion enterprise valuation, is roughly three times the reported asset valuation. This means that $16 billion in real estate assets are valued closer to $50 billion by the market, even after the sluggish share price. This looks reasonable as revenues are reported close to $4.5 billion, but this kind of real estate carries a lot of costs with them as referred to above, sill resulting in a high valuation in my book and high free cash flow multiples.

Moreover, supply keeps increasing, and the lower occupancy rates suggest that the pricing boom has come to an end as well. Therefore, I am still cautious on the sector at large, even as it was and perhaps still is regarded as a REIT darling here, even as a quality name like Public Storage pays a >4% dividend yield here.

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