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Public Storage: A Great Store of Value

- By Daniel Seens

Company overview

Furniture, records, kids toys, electronics, tires, golf clubs, snorkeling equipment, bicycles -- the list goes on and on. Anyone in middle age has spent years accumulating things. And when we move out of our parents' homes, we need somewhere to store all these things. But where? You guessed it: Public Storage (PSA).

Public Storage is a real estate investment trust (REIT) and the largest owner and operator of self-storage facilities in the U.S. Public Storage owns and operates about 2,336 self-storage facilities located in 38 states within the U.S. It also owns one self-storage facility in London, England which is managed by Shurgard Europe. In total, Public Storage estimates that it owns, directly or indirectly, about 154 million square feet of rentable storage space in the U.S.

Public Storage also has a sizeable footprint in the U.K., where it holds a 49% equity interest in Shurgard Self Storage Europe Ltd. Shurgard owns about 218 self-storage facilities, consisting of about 12 million net rentable square feet located in seven European countries. It also controls a 42% stake in PS Business Parks Inc., another publicly traded REIT that owns and operates office space and commercial properties.

There is nothing complicated about Public Storage's business model. It owns large wharehouse-type structures that have been subdivided into small, bare, dry locker spaces that are rented to customers on a monthly or annual basis. Typically, locker spaces are not climate controlled, range in size from 25 to 500 square feet, and are easily accessible to customers. The typical Public Storage warehouse holds about 500 rentable unit spaces. On average, the company estimates that it earns about $12 per square foot per year to rent its storage spaces. This includes revenues earned for both the storage space itself as well as insurance sales to cover losses for any goods damaged as well as the sale of locks and cardboard boxes.

Purchase considerations

When evaluating this company, it's important to note that the focus is on income generation, with less emphasis placed on the value of owned real estate and land (which is a perspective that many investors will take). That said, there are various reasons, from an income perspective, to like this company.

  • Moving forward, megatrends in the U.S. and European housing markets will bode very well for Public Storage.

    • Families are now living in smaller houses, with smaller yards and smaller basements, giving them less space available to store items.
    • More people, particularly the younger generations, are choosing to rent rather than own, which is creating a greater need for storage space.
    • People are gravitating closer to city centers and away from the suburbs, resulting in more small-space living, and a greater demand for storage.
    • Older seniors and baby-boomer retirees have started downsizing, selling homes and moving into smaller apartments and condos, again creating the need for more storage space.

  • Public Storage has tremendous market penetration, with its primary facilities located in New York, San Francisco and Los Angeles.
  • This company is a total "cash cow," generating free cash flow margins of about 60% per year over the last 10 years. Provided that the revenue base remains stable and the company can continue to tightly control cost, it should be able to maintain these margins well into the future. This company appears to be the most operationally efficient business in the industry and not likely to change anytime soon.
  • The company continues to build brand recognition and, with the continued development of new facilities, should be able to capture additional market share or at least protect its current piece.
  • The company has demonstrated consistent success in its acquisition activities, which will prove a powerful source of growth moving forward, as it currently controls only an estimated 15% of the market.
  • This company offers a nice dividend, yielding 3.7%, with dividend growth averaging 7.2% over the last three years. This is ranked better than 80% of firms in the industry.

For all the reasons to like this company, of course there will be some reasons not to. Most importantly, intensity of competition within the industry remains high, and while it has arguably the best brand in the business, brand alone does not count for all that much in this industry. Public Storage must continue to grow its locational advantages if it wants to seriously capture market share and dominate the industry the way it should.

The other thing not to like about this company is that sales have started to display more cyclicality than previously. This might be attributed to the emergence of more second-hand online sales platforms, such as Craigslist, making it easier for people to sell their things rather than store their things.

Estimating sales growth

When assessing the competitive strength and investment merit of a firm, we first assess sales. Ideally, we invest in companies whose sales are strong, consistent and generally growing faster than nominal GDP growth (that is, real GDP growth and inflation combined). Based on Public Storage's historical sales data, you can see that Public Storage's revenues have grown by about 4.7% over the last 10 years. This compares to average nominal GDP growth of 3.3% per year over the same period. Public Storage's sales have grown by 6.8% per year over the last five years and 5% per year over the last three years. It is worth noting that Public Storage's three-year revenue growth rate is ranked higher than 74% of the 560 companies in the REIT - Industrial Industry.

This company's future growth trajectory appears to remain positive and it is operationally on solid ground. It also retains substantial pricing power. We expect impressive things from this company's stock in the future.

The second thing wedo when assessing sales is to look at consensus market estimates. As reported by Morningstar Inc., the market is projecting 1.7% annual growth for this year, 8.2% annual growth for next year, and 0.0% for the year after that. These growth estimates translate into $2.8 billion in sales for this year and $3.0 billion in sales for next year. The projected increase in sales is expected to be driven by an increase in product demand, rising prices and improved storage capacity.

The third thing we do is compute a company's sustainable growth rate, which reflects the rate of growth in sales a company can support given its existing earnings power, capital resources and dividend payout policy. In any given year, a company's sustainable growth rate is calculated by multiplying its return on equity by its retention rate. Rather than rely on data from only one year, however, we calculate sustainable growth by using the firm's three-year average return on equity and three-year average retention rate. Public Storage's return on equity averaged 14% over the last three years while its retention rate averaged 2%, giving the company a sustainable growth rate of 0.3% per year.

Here is a brief recap of what the sales data shows. From our view, it is not unreasonable to estimate that sales over the next five years could grow at a rate of somewhere between 0.3% and 6.8%.

We select a rate of 3.2%. This represents a blended rate forecast reflecting consensus three-year rate projections scaled by a 10-year average incremental change for the last two years of the five-year forecast horizon. With $2.8 billion in sales generated last year, this means that we believe that sales will reach about $3.2 billion in five years. This estimate reflects our understanding of the firm's historical results, market demand, pricing trends, levels of competition and changing regulatory requirements.

Estimating earnings per share

Next is to estimate growth in earnings per share. The method applied below takes the sales growth projection -- in this case, 3.2% per year -- and subtracts the expenses and taxes. What is left are the earnings. Then, divide by the projected number of diluted shares outstanding to determine the earnings per share (see table below).

A projected growth rate of 3.2% results in about $3.2 billion in sales five years out. Next is a calculation of the company's pre-tax profit margin (what's left over after expenses but before taxes are subtracted). In the figure below, Public Storage produces some pretty stable margins -- 63.5% in 2018, 54.8%in 2017, 57.2% in 2016 and 55.4% in 2015. The average for the last five years is 56.7%, and the average for the last 10 years is 52.7%. We believe that Public Storage's margins will hold at 52.7%. At this rate, projected pre-tax profits on $3.2 billion in sales would be about $1.7 billion. This means expenses would amount to $1.5 billion.

The next main consideration is determining the number of diluted shares that will be outstanding in five years. Public Storage has increased the number of shares outstanding over the last decade. There were 168.7 million shares outstanding in 2008. Then the number of shares went to 172.7 million in 2013 and 173.9 million in 2016. At last count, there were 174.3 million shares outstanding. This data suggests that the company has been issuing about 600,000 shares per year. We rely on the company's historical share repurchase activities to guide our estimation process. As such, we project share issuances of 600,000 per year over the next five years.

With shares estimated at 177 million in five years, earnings per share are expected to rise at an annual compound rate of 2.4% over the period. This is lower than our projected five-year revenue growth rate. Based on this earnings per share growth forecast, we expect earnings per share of $9.60 five years out. Results of this forecasting procedure are summarized in the table below.

Forecasting a target price-earnings multiple

Public Storage's stock has traded with a relatively stable price-earnings multiple over the last decade, averaging 33.9x over the last 10 years, 32.7x over the last five years, and 29.2x over the last three years. The firm is trading at 25.5x trailing 12-month earnings per share and 28.7x expected future earnings.

For determining an estimated target price-earnings multiple, the first thing to do is eliminate any outliers from the historical data series. This includes abnormal price-earnings ratios that are not reflective of the normal operations of the firm, and this could be the result of abnormal growth or significant one-time non-recurring charges or gains.

Next, run an optimization procedure that tells what price-earnings multiple yielded the best forecasting accuracy over the evaluation period. If, in our judgement, this multiple continues to accurately portray the earnings and cash generating power of the company as well as the growth and risk characteristics of the firm, we will use this multiple as our target multiple. If not, we will adjust the multiple upwards or downwards accordingly.

The figure below presents the historical price-earnings profile for Public Storage. We use target price-earnings multiple of 30.6x, which reasonably characterizes the risk-return attributes of the company's stock. This multiple represents an expansion of 29.3% relative to the current multiple. It also represents a contraction of 13% relative to the five-year average price-earnings multiple.

Setting a target price and valuation range

Take a look at the price history of the company's stock. From the figure below, the spread between the high and low stock prices has increased over the last 10 years. The price is $217.78, with a high in the past 10 years of $276.27 and a low of about $48.05. Keep this variability in mind when establishing an upper and lower valuation range. Specifically, given the firm's historical stock price behavior, the stock should fluctuate by at least $42.11 over the course of a year.

Given the selected target price-earnings multiple of 30.6x, to determine a price target five years out, multiply this by the earnings per share estimate. Earnings per share are estimated to reach $9.60 in five years, giving us a target price of $294.32. This price is higher than the current price.

To properly judge to what extent the stock may be under- or over-valued, we need to determine a fair-value range within which we expect the stock to trade. To do this, we rely on the trend-adjusted average annual trading range for the stock, which from the analysis above is $42.11. This means that, given the target price estimate, we expect the stock to trade naturally, and fairly, between $273.27 and $315.38. The result of this is that when the stock is trading below $273.27, it is in the "buy zone" and when the stock trades above $315.38 it is in the "sell zone." Currently the stock is in the buy zone.

Return potential

So what return can be expected for holding Public Storage's stock? Well, from the above analysis, the stock price is expected to appreciate 35.1%. It is also expected to earn dividend income of about $40.00 over the evaluation period. Added to our price estimate, this means we could earn a compound annual rate of return of 9%, provided our estimates prove accurate.

All in all, we are reasonably happy with this company and believe that it offers sufficient return potential to qualify for investment.

Disclosure: We currently do not hold any positions in this company.

This article first appeared on GuruFocus.