Extra Space Storage Inc. (EXR) Q1 2013 Earnings Report, Transcript and Summary

Great. I am the CEO of Extra Space, Scott Stubbs is our Chief Financial Officer. And we appreciate your interest today. Quick overview, Extra Space is the number two operator of self storage in the United States. We have 910 properties under the Extra Space flag located in 34 states Washington DC and Porto Rico. Of the 910 properties, 448 are wholly owned. 281 additional assets are held in joint venture relationships with likes of Prudential, TIAA-CREF, Bristol, Harrison Street and others. Nonetheless, we have 181 assets that are held only in the name Extra Space which is the trade name but they’re owned by someone else. And it’s branding a system, an employee issue where we’ve taken control of the asset and managed it as if it were our own. So, three different buckets about half wholly owned and about half in the managed relationship. 2012 was Extra Space’s best year ever since 1977 when the company was created. We put up nearly – about 6.5% revenue growth and over 10% NOI growth. The FFO growth year-over-year was 33% and we’re very pleased with that result. Part of our success last year was $700 million in acquisitions, of which about $500 million came from the managed relationships. And $200 million came out of the open market. If you look at 2013, we are optimistic about the future of self storage for a couple of reasons. Number one, there is virtually no new supply. And it’s well known at this point that the larger national operators that are more sophisticated are taking market share from the smaller operators and as we look at record high occupancy, our ability to reduce discounts and incentives and ability to street rates at the mid-point of our guidance, we’re forecasting FFO growth north of 20%. One of the unique things of Extra Space is, we believe we have five levers of growth. Other storage companies have levers maybe a few of these but Extra Space has uniquely has all five. Number one, our core property performance, on average has been best-in-class for seven years now, revenue growth, expense control and then NOI growth. Number two, we have lease of assets, assets that we have built, we have paid for that are not fully yet stabilized and we for the past decade at Extra Space have been the most prolific developer although we are no longer in this development game, we do have the self assets. Number three, I’ve talked about acquisitions, we participated in the open market and done well and also participated in the off market where the managed staffs that have never even made it to the open market. As I mentioned, last year with $500 million of managed assets where there was one call and one call only to Extra Space. And we were able to trans that off-market which meant that we bought right. We have our third party management business which is now the country’s largest for self storage assets 181 assets and growing. And lever number five is that we have turned in insurance that is offered across 910 Extra Space branded assets. More than 90% of the customers come in at the door are offered this general insurance. And in terms of in-place insurance we’re in the high 60s. So, you take those five levers of growth and we have produced industry leading results and we are very optimistic about 2013 and beyond because of the forward mentioned items, virtually known as supply and let me underscore that just so that it sinks in and there are 54,000 self storage facilities in the United States. The last number I saw from FW Dodge is 196 assets across the entire United States under construction that is well below the natural population increase which is on in about 1% and that were considerably less than 0.5% in terms of new supply entering the market. And then the larger more sophisticated offer that is taking markets. So, with that, we’d like to open this session up for questions. And we’ll do our best to address them. Brett? Brett Krause – Citi: Spencer, EXR has been one of the best performing stocks over the last four years I mean, consistently you’ve done extremely well. What part of that is that there are some people that think the stock looks expensive right now. I’m just curious how do you look at value in the current environment and when you think about the five levers of growth, the five lever of I guess shareholder, are you going to drive shareholder returns. Which one do you think is going to be the most value enhancing for EXR?

Well, I think there are three parts to that question. First part is, in terms of valuation, I would say, if you look at us as a traditional self storage company, you might come to that conclusion but I might remind everybody just five years ago, if you look at the Extra Space platform, we had 567 properties today we have 910. Well, five years ago the worst economy, the worst recession in any of our lifetime hit us. And during a very difficult time, Extra Space grew dramatically. So, I think we have demonstrated we are a growth company and that traditional ways of looking at valuation may or may not apply to our company that is in otherwise dodging industry. Number two, at the levers of growth, I think our core property performance is a significant driver. But let’s not get lost on the fact that $700 million worth of accretive acquisitions, last year and a very successful year prior to that are fuelling the growth of our performance – the performance of Extra Space. So, in terms of valuation, only the individual investor can make the determination that I can a 33% FFO growth last year over 2011, and a 20% FFO growth forecast in mid-point for 2013 speaks well for our confidence of how we’re performing. And I think one thing that’s perhaps scared the market a little bit recently is the fact that if you look at growth, it does seem to be decelerating for the sector but obviously staying still quite strong. How many more years do you think you can see this sort of bug average type growth caused more than say 3% to 3.5% NOI growth. Brett Krause – Citi: I’m going to turn that question over to Scott, our CFO and let him respond for a few minutes.

Thanks Brett. I think that really the growth should continue as long as the supply remains constrained, self storage is large a need based product. We’ve seen during the downturn, we’ve seen good times, we’ve seen – when times were good in 2007, 2008, our self storage did very well. So, self storage is a need based product. When people move, people need self storage. It’s not something that you can adjust the price on and create demand. So, we see things looking good as long as the supply remains constrained based on the number Spencer quoted earlier from FW Dodge have 200 properties that are inter permits. I think that you probably have at least two to three years. It’s going to take a year or two to get it permitted and entitled and then another year to get it built. Brett Krause – Citi: Can I just ask you a question about development? Obviously you guys got out of the development business when the financing wasn’t available. Is there a way to get back into the development business without creating an in-house capability , buying stuff or encouraging others to develop for you to provide product to a market which could obviously use some?

I think it’s difficult to do what you’re suggesting and do it rescale. I think that the bigger we get, the more difficult it is to really add scale to the development program. At our peak we developed 15 properties in a year. And that was on a base of 700 or 800 properties. Now that we’re over 900, half of those being owned it becomes more and more difficult. In addition to that, we’ve looked at the risk adjusted returns on our developments compared to acquisitions we find it difficult to justify the risk that we’re taking. We feel like obviously there is a good return with development, but we’re not sure that the risk justifies the return. Brett Krause – Citi: You said that there is only 200 stores that were currently under construction. What would be a more normal, call it pace to meet demand, I mean what would you need to see in terms of thinking okay, like this is going to be concerned above this level that percentage?

So data-point 2003 through 2007 that five-year period 13,011 self storage facilities were built in the United States that’s an average of 2,600 a year. That’s when I would say supplier is outpacing demand. Well, those construction projects have been completed. They are leased up, they are full and now there is virtually normal supplier and I would say – I would start to have concern one we’re building more than a 1,000 year because we’re currently beyond the natural population increase.

Yeah. I mean, if you assume that the population is 300 million or 1%, 3 million people adding to the population every single year, if you added 1% to the self storage population, 50,500 properties per year is probably normal and keeps up with population growth. Brett Krause – Citi: What percentage of households use storage, do you know that, is that relevant just that you look at, I guess probably not?

That’s hard to say, what I can tell you is 56% of our customers that walk through the door at any given time have never used self storage before. So, clearly the product awareness and product usage is high. Brett Krause – Citi: One of the things I was a little bit confused about on the call was that you said that your growth this year is mainly going to come from occupancy and then reduce discounts but then you also said that you were expecting to see street rates increase about 4% or 5%. Just kind of help us understand what’s driving your growth, is it occupancy and discounts or is there going to be ailment at street rates as well?

We are expecting our occupancy to be as much as 100 basis points, 200 basis points ahead of last year, probably closer to 100 basis points that’s kind of what target occupancy this year as we go through our rental season and throughout the year. In addition to that, our discounts and we started 2012, we were basically flat to the prior year. They decreased by 20% in the third and fourth quarter. So, you went from zero to between 15% and 20% in the fourth quarter, we’re projecting those to now go from call it 20% back to zero throughout 2013. Discounts obviously affect your net rentals, so the more that we can save on discounts obviously it’s similar to a price increase as our occupancy has increased, our discounts have decreased. Brett Krause – Citi: You said that discounts were 4.2% of rental income, is that right?

Correct, they are just over 4% of rental income today. At the start of the year they were about 100 basis points higher than that, so they were 5.2%, 5.3%. Brett Krause – Citi: Right. Is there I guess a lower limit to where that can go and then obviously I would think that just to get the customer in the door you need to offer some kind of incentive or can it really go to zero?

I think it’s difficult to say, I think it’s going to be dependent a little bit on supply, during the period Spencer referred to earlier when you had a lot of new supply added to the market. I think you had to discount more in order to get your prorate share rentals when everybody is offering a discount. If supply remains constraint I think you can see discounts going down, I’m not sure that they would ever go to zero. Brett Krause – Citi: Thank you. And you said that you were trying to get smarter about when and how you offer the discount, so you testing different types of discounts and how are you evaluating that?

We’re continually testing different types of discounts and then obviously evaluating through occupancy and through the rate of close, the rates at which we close our rentals. But we’ll test everything from half month – one month half-off to we’ve tested as much as two months free, three months half-off, different types of rental discounts. We’ve gone as far as testing and giving someone an American Express $25 gift card to see if that moves a needle more than just one-month free. So, we’re constantly testing those types of discounts.

And as far as your tenant reinsurance business you mentioned that the penetration I think was in the high 60s. Is it reasonable for us to expect double digit growth for at least the next couple of years because of that I mean, there is no reason I couldn’t go up to 90% penetration right?

Actually there are reasons why it can’t – if you figure that 20% of your customers are commercial users with their old P&C policy that knocks out part of the potential base. You still have some homeowners that will come in and say I’m going to put this on my homeowner’s policy. So, we’re in the high 60s, we think it’s going to continue to drift up. I think there is a physical level or theoretical limit probably in the mid 70s and we hope to get there but that’s going to be a multi-year process. Brett Krause – Citi: And obviously, I’m sorry, go ahead.

Speaking of physical limitations we’re now in the 90% plus occupancy range, where do you see that going to and what is fully occupied and what does pricing do as you get up there and street rates and all that other?

Okay, so what’s interesting about self storage is there is a high transactional velocity leaning about 7% of the customers rent every month and about 7% vacant every month. So, if you look at frictional occupancy, somewhere in the mid 90s, theoretically is approaching full occupancy. And for us, we think that there is some occupancy upside for us, although we just want to continue to shrink. As you get into the low to mid 90s. And the benefit of being more highly occupied is kind of three-fold. Number one, you have pricing power for the customer walking in the door, because you don’t have to give anything away in terms of rate. Number two, concessions for incentives to induce people to rent, you can decrease and that’s what we’ve seen in 2012. Number three, you cannot pass along an existing customer rate entries to space that is not currently occupied. And I think you take those three benefits and I think that there is some headroom in terms of our performance but to expect extra space, to be operating like an apartment where you have one, two and three bedrooms and you are running at 98% occupancy I think is not reality because we have 23,000 different size codes. And to find out what the market will bear you need to have some occupancy so that you can figure out what the next incremental rental will tolerate, think of hotels, think of airline safety, that’s where our revenue management has headed philosophically.

I was just curious, we’re seeing a lot of commercials now for things like the portable on-demand storage, mobile storage is getting into the residential space. Where do you see that or do you see that as a threat or is that a different type of product to a different type of customer?

Portable storage?

Yeah.

It meets the demand. It’s a logistics business and it’s a completely different business from the one that we are currently in. It serves the need but the price point, the usage of it is only a small percentage of what has traditionally been the self storage behavioral pattern. And it’s a factor but it’s not something we see ourselves getting into once again, we’re in a real-estate business that is logistics.

Over the last couple of years we’ve seen your occupancy come up and obviously a big part of that has been stealing market share from your private competitors, it’s giving your better advertising and revenue management platform. To the advantage of that you have on these platforms matter less now that you’re above 90% occupancy, I mean, if there is no more occupancy for you to steal the value of your revenue management system, I mean, your advertising system, matter a little bit less?

I would argue actually that it matters more, that the goal is to maximize revenue. It’s not necessarily about maximizing price or maximizing occupancy, it’s been this great debate what Extra Space is interested in is driving the maximum revenue at each facility and I gave three reasons, previously as to why more highly occupied is better than less highly occupied. So, for us, as we look at the sophistication of our revenue management systems and our internet and interactive marketing technologies and programs, what we want to do is go out and continue to drive the maximum number of customers of the highest possible price point with the lowest promotional dollar affixed to it to produce the highest and best result. And that speaks more to sophistication and using big data and all of the customer information we have to finally tune how we present the right price with the right promotion at the right time to the right customer because the 523,000 customers to say they all fit under one generic description defies logic. And to say that a customer coming to us that’s a college student in May is just as valuable as the customer coming us in November that might stay up to three times as long. And the lifetime value is the same, that doesn’t makes sense. And so for us the refinement of what we’re doing to further drive incremental gains is what’s important to Extra Space. And I think we’ve only begun to scratch the surface. It’s not always just about occupancy, it’s about maximizing revenue.

And what do you see as the main differences as you look at it between you and your competitor’s revenue management system, obviously there seems some nice gains as well. But what do you see as sort of the advantage that EXR has?

It’s difficult to comment not knowing exactly what each of them are doing. But I think that we’re focusing on I think that we’re trying to obviously decrease the amount of discounts in the upcoming year as well as making sure that we offer the street rate is going keep your occupancy up and maximize the revenue, yeah, again it’s difficult to comment on the revenue management system and where they are in the process.

The only other comment I might offer Eric is we are on our third generation revenue management system. I think not exclusively but I think probably maybe more aggressively we have pursued the automation of our algorithms and the sophistication of the coding for what we call our Black Box, that’s 56 different variables to help determine the pricing size-code by size-code, because once again the 523,000 customers and 23,000 different size codes, this is far beyond the grasp that a single human to rationally figure out what are the pricing ought to be at given point. And we’re to the stage where our pricing literally is updated daily throughout the entire system. And in some locations as frequently as five-minute intervals depending on the transactional velocity of a particular site. So, I don’t know where the company’s are to Scott’s point but I can tell you we are on our third generation and we still have a long way to go.

As your average cost to acquire customer come down as you’ve been commented – gone through the evolution of all of your systems?

Yeah, there is Google inflation so it’s getting more expensive to participate on the internet. But we’ve also gotten a lot smarter about where we’ve been and how we’ve been. So, one of the data points that we use is we bid on 13 million search terms every day. Some search terms yield a higher return on investment, and other search terms have a lower return on investment. And what we want to do is bid on terms where we know we can offer a solution. So, if someone puts in the climate control self storage for Lauderdale, and we have a site a mile from this hotel so I mean, we’ve lived here, we’re on a condo next door. Because it says climate controlled self storage for Lauderdale, we know that that customer is exactly the feature set. They’ve specified the locale and we know that 52% of the time that customer is going to rent within 24 hours. We’re going to go after that search term very aggressively. If someone just types in self storage Florida, we’re not going to bid $0.01 because it has no value to us because we don’t know if we can go after and deliver a reservation and create it into a customer that’s paying rent. So, 30 million search firms and we’re very interested in driving down the CPA or Cost Per Acquisition through a more intelligent approach typically on the search terms that actually yield the result.

And what is your cost to acquire customer or how do we look at it?

We haven’t disclosed the CPA.

Got you. I know you’re coming off one of the best years in terms of acquisitions, like you said $700 million of accretive acquisitions last year and obviously transactions are tough to predict. But in talking with your JV partners, with third party management partners, do you think this year is going to – is it sizing up to be another great year in terms of acquisitions?

We’ve given guidance of 150 million in terms of acquisitions this year. I mean, if you look at last year, up to 700 million, 500 million came from our JV and managed population. So 200 million I think you’ve seen some cap rate compression. So, we help to do the 150 and obviously hope to do better.

Can you guys talk about the acquisition underwriting, how it’s different between assets that are annual system versus the pre-market, how do look at that, what are more of the targets there?

The acquisitions that come from our system, obviously there is zero execution risk. I mean, obviously in our system we have our people working there already. Considerations that we always do with any acquisition is we underwrite year-one revenues. If it’s something we’ve managed obviously, we’re very comfortable in underwriting year one revenues. Outside of our system you’re going to assess a lot of different things like the sophistication of the seller, so for instance if you buy something from a seller who doesn’t have any internet presence and doesn’t have any type of – they don’t take credit cards or things like that then we’ll go to a site that’s nearby. So often we’ll have a site within a mile or two, so we’ll be able to come up with some revenue projections on that. Generally we try to be more conservative than not, we’ll always apply a management fee to that, so the cost to manage, so that we – and then we would apply our expense structure to you guys. So, it’s somewhat similar but going to be relatively conservative in both cases as far as projecting going forward. One of things that we found – we can get ourselves in trouble if we’re not real careful is, when we go in assuming that the owner didn’t know anything and come up with some wild growth expectations, there has been occasions when you find out they were actually pretty good. So, we’re prepared to be more conservative.

Is there a rule of thumb that assets have come into your system, how much do you end up saving or in comparing to revenues or is it all?

There is not really a rule of thumb it’s going to depend a little bit on the properties. In this past year we bought four properties in the Northern New Jersey that we actually bought them through an auction. And it’s something like that where they were in receiver shift, clearly we’re not going to focus as much on the past performance as much as what our properties in the area are going to do. So, that’s not necessarily a rule of thumb.

Someone mentioned on the call that I guess from talking focus that they were expecting some decent sized portfolios to come to market fairly soon. Is that your expectation as well?

Only time will tell. There are a lot of rumors floating out there. And I would be remised to say yeah, we think that’s going to happen, I’d rather say, let’s see what happens. But there is interest in transacting, obviously the larger public companies have access to capital, but the smaller guys generally don’t. And whatever shakes lose, I believe extra space would be a competitive bidder. And hopefully we’ll get our first share of what’s out there. I think historically if you look at our track record, we’ve been acquisitive. And we’ve gotten a reasonable amount of what’s to be had at cap rates that are accretive to this company. We’re very interested in being disciplined and only time will tell what’s going to be coming forth.

What’s your thoughts about the growth and the third party managed business this year going forward with, how the level of enquiry is and what do you think about conversion rates all of that?

I think on the third party managed business, the rate of enquires is accelerating. Our ability to add contracts is accelerating. And I’m optimistic that the awakening that’s taken place in the market, the smaller operators are at a significant disadvantage as continuing to the highlighted quarter in and quarter out whereas you have the public companies operating at record occupancies and putting up record results. And the smaller guy is still waiting out a storm that is long since passed. And with that, we’re finding individuals and smaller groups saying I’d like to align myself or I need to align myself, because the old way of doing business drive up in yellow pages, it’s only half correct. It’s still drive up but the internet is passed by and I don’t have the resources to compete in the world in which the larger, more sophisticated operators are doing business. So, expected acceleration, only a threat for space but with larger public companies to have more of shot at taking on management contracts and obviously when you bring on a management contract, it’s good for business because hopefully it turns into an acquisition opportunity somewhere down the road.

So, what type of growth numbers do you think about for that business?

We haven’t given guidance on that. I will just tell you it’s accelerating and we’re optimistic that that will continue to be a growth pinnacle for Extra Space. Brett Krause – Citi: Nice try.

I guess, it’s a third party management business, I mean, is it really just about lining up acquisitions, I mean, if that weren’t a possibility and the owner came to you and said look, I really just don’t want it from my asset, is that something you considered managing, does the economics are on the third party management business mix sense in it itself?

Yeah, there are four reasons to engage in this activity. The one is, you can collect a management fee but let’s call that breakeven, it’s not compelling, it covers your cost. Number two, you are able to tap into a potential acquisition pipeline. Three, you’re able to sell tenant insurance. What’s interesting is most of the smaller operators have an insurance penetration rate of maybe 20% or 30%. Our penetration rate is in the high 60s for the in-place. And number four, the long-term is applied for mobile which we can spread our fixed expenses, the larger of the denominator the more efficient we become. And so, even if we can’t buy that asset ultimately which is the mentality we have when we go into it, we can’t assume that we’re going to transact. We’ll enter into agreements to manage because of the before mentioned reasons. And particularly where it’s an asset or a portfolio is where we’re already doing business. it can be very compelling. If you add one property in Southern California, where we have a very large presence, the incremental cost to manage that is not a lot. And we put up the tenant insurance and we decreased the denominator stuff. It’s a compelling business with or without the acquisition. But ultimately the strategic reason for Extra Space to be in the third party management business is to create a quayside proprietary acquisition pipeline.

Why is the penetration so low for the third party companies, I mean, is it, what are they doing wrong that you’re doing right? You said 20% to 30% penetration versus…?

On the tenant side, it’s because of focus, because of training and because of the resources. In offering the tenant insurance you need people that need to understand the value of it, and are willing to offer it, but the point is, we are not insurance sales people. We don’t sell the insurance, we simply offer it. And we participate because that is captive to the rate, our captive insurance company takes all the risk and takes all of the revenue. And for us, a lot of other companies just don’t have the economic incentive to focus on it because it’s provided by someone else, they might only get $0.40 or $0.50 on the dollar that’s coming through the door, then if they’re trying to pay a commission of their sales person or their store manager, the economic incentive isn’t always compelling this when you have 100% coming because you’re on the captive insurance company. So, it’s been a matter of focus and training and execution at the site level. Brett Krause – Citi: Any other questions? Okay, we’re going to end this session and I’m sure you stood us by now with our typical rapid-fire questions. So, let’s get started here. What will same-store NOI growth be for your property sectors or the storage sector in 2014?

4% to 6%. Brett Krause – Citi: Okay. And if you had to, what property sector would you invest in with your personal money other than your own?

Self storage, there is no new supply. And we’re talking market share from the smaller operators. Brett Krause – Citi: Yeah, but if you had to look outside the fantastic fundamentals storage, where would you look?

Medical. Brett Krause – Citi: And last question, do you expect year from now to see more or less publicly traded storage companies?

My personal opinion is it will be the same. The reason, I think there is not a lot of appetite for a small new entrant into the storage space on an IPO, we’re not hearing the appetite for that. So, I’m going to stick with what we have for primarily focused med, you hold five publicly traded companies offer in storage. Brett Krause – Citi: Why is traded that?

That’s the million-dollar question. There could be, but I think it will be the same. Brett Krause – Citi: Okay, thank you.

Thanks very much.