Iron Mountain Incorporated (IRM) Q2 2008 Earnings Report, Transcript and Summary

Good morning, my name is Tasha and I will be your conference operator today. At this time, I'd like to welcome everyone to the Iron Mountain Second Quarter 2008 Earnings Webcast Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions]. Thank you. Mr. Golden, you may begin your conference.

Thank you and welcome everyone to our 2008 second quarter earnings conference call. After my announcement this morning, Bob Brennan will give his state of the company remarks followed by Brian McKeon, who will deliver the financial review. When Brian is finished, we will open up the phones for Q&A. For our custom, we have a user-controlled slide presentation on the Investor Relations page of our website at www.ironmountain.com. Referring now to slide two, today's earnings call and slide presentation will contain a number of forward-looking statements, most notably our outlook for our 2008 financial performance. All forward-looking statements are subject to risks and uncertainties. Please refer to today's press release or the Safe Harbor language on this slide for a discussion of the major risk factors that could cause our actual results to be materially different from those contemplated in our forward-looking statements. As you know, operating income before D&A or OIBDA and free cash flow before acquisitions and investments are metrics we speak to frequently and ones we believe to be important in evaluating our overall financial performance. We provide additional information and the reconciliations of these non-GAAP measures to the appropriate GAAP measures as required by Reg G at the Investor Relations page of our website as well as in today's press release. Before I turn the call over to Bob, I'd like to let you all know that our 11th Annual Investor Day will be held on Wednesday, October 8, 2008 at the Grand Hyatt Hotel in New York City. Stay tuned, we'll be releasing more information as it becomes available and the best way to stay informed is to sign up for e-mail alerts at the Investor Relations page of our website. And with that, I would like to introduce Bob Brennan, our President and CEO.

Thank you, Stephen. Good morning, everyone and thanks for taking the time to join us for our second quarter earnings call. The format we will use today is similar to our past calls. This is my first call as CEO and I'll start by giving you my report on how the business is doing and reference our strategy as we go through that. Afterwards, Brian will take you through the quarterly results and provide an update on our full-year outlook followed of course by Q&A. So let's get started. Here are the key messages I want you to hear today. First, Iron Mountain is performing well and we are on track to delivering against our full-year financial goals. Next, we are continuing to advance the growth strategy we have been delivering on for years, the strategy that's driven by solid expansion of our core business, which is of course supported by continuing strong growth and services that leverage the investments that we've made in storage, by expanding our international presence in markets where we see strong economics and then building scale for our digital business to meet large expanding market requirements. The last message that I'd like to drive home is that the team at Iron Mountain is taking a very disciplined approach to growing our business and that discipline is producing the desired results. I will now provide a quick summary of our Q2 financial performance, which Brian will review in detail after I'm done. Overall, we delivered strong revenue and OIBDA growth for the second quarter with each up 15% compared to the same period last year. Both numbers were at the high end of our guidance range and we also continued to drive strong growth across our major business segments with all segments performing well across the board. More specifically, there are three key areas I want to highlight that supported our strong Q2 financial performance. First, service revenues continued as a key driver of our overall growth. Second, our digital business is performing very, very well and third, we're really getting clear benefits from having a broad portfolio of businesses. So let's go to the service component first. Consistent with our long-term strategy, we're building off a strong storage revenue base, which continues to generate solid growth rates so that we can introduce new services that help our customers solve their information protection and storage problems. In the second quarter, overall revenue growth was led by service revenues, which were up 18% on a reported basis including benefits from acquisitions and 9% in terms of internal growth. We're seeing the positive benefits from our strategy to invest in services that leverage our strong storage relationships. Our international segment reported strong service growth, supported by continued momentum in Latin America where our Document Management Solutions continue to be a key growth driver as well as in Europe where we're seeing significant benefits this year from special projects specifically within the UK. North America also posted solid gains despite pressures impacting many of our customers. As you might expect, we are seeing some impact from a worsening economy on our complementary service revenue particularly with respect to more discretionary projects. At the same time, we are generating solid growth in our shredding business supported by strong paper prices and service volume growth. It's worth mentioning that Iron Mountain Digital also delivered a strong service revenue performance in Q2. In advancing our growth agenda, you should expect service revenues will continue to expand as a percentage of total revenues, which will in turn drive higher returns. This builds on our foundational storage relationships with our customers, maximizes our potential to service them and it does so with less capital intensity and therefore higher returns. In summary, we see the expansion of service revenues as central to maximizing our opportunity and our value as a company. With regards to Iron Mountain Digital, Iron Mountain Digital continues to perform quite well with 16% internal growth in Q2. Our eDiscovery, archival and intellectual property management businesses were all very strong contributors in this quarter. Iron Mountain Digital is the leader in providing digital storage as a service with annual run rate revenues approaching $250 million this year accompanied by solid returns. Our early vision as a storage and service provider is being validated as the market continues to expand at a rapid pace and continues to attract more competition. We believe we're particularly well positioned against the competition to capture our share growth because of two primary factors. First, is the Iron Mountain brand. Iron Mountain is a brand that's been built on trust because customers have really relied on us to protect their data for decades. We have no agenda in using their data and selling them equipment and doing anything other than providing them strong SLAs around the long-term preservation, protection and storage of their data. The second is our business model. Storage is a service that something that we started quite a long time ago, a supply wheel [ph] business that you're familiar with. And in digital just as in our physical businesses, it has the same recurring properties. It's taken us some time to get to $250 million in annualized run rate revenues for Iron Mountain Digital. If you think about our early entries through the Connected and LiveVault acquisitions, both those companies were started their revenue in the mid-90s. So, it takes time to build the business but it’s a very sticky business and it will take time and a very different mindset from our competitors to successfully drive this type of an approach. I think it's worth just settling on a point here. Our primary competition for Iron Mountain Digital is customers who seek to solve these problems themselves by purchasing hardware and software from traditional technology companies and running it in-house. We see that that’s moving towards us as companies become increasingly frustrated with the explosion of data that they are facing and the complexities of doing it themselves, not to mention the cost. So, we are pleased with our progress in Iron Mountain Digital and remain optimistic about our potential going forward. The third theme underlying our strong results is the strength of our business portfolio. We’ve evolved many businesses over the last decade all building off of our strong storage foundation and expanding our geographic reach and adding our service capability and providing a broader and broader range of customer solutions. All of our businesses are contributing whether you look at them by product or geography across the board. We will continue to invest against this strategy. Balanced of course with a disciplined focus on driving return improvement, this strategy has been working and we expect to continue to advance it. So, those are the three underlying themes to Q2 performance. So, as we go forward and drive our growth goals, we'll remain focused on management cost, especially given the softer economic environment we're all operating in. We are seeing some impacts from the economy on certain of our business. So in this contact, we are being particularly disciplined about prioritizing and concentrating our investments. In terms of managing cost, we're still working through higher cost growth effects from acquisitions and overhead investments that we initiated in 2007. At the same time, we are targeting and expect moderated overhead growth as we work through the second half for this year. I want you to know that we are committed to investing to advance our growth strategy. At the same time, we are also committing and committed to delivering against our annual financial objectives. I believe we can manage this balance effectively. Overall, our solid start to the year puts us on track to deliver our full-year goals. We made some positive revisions to our guidance this morning, which Brian will discuss in more detail. I will ask that you not get too excited about that. Our business remains solid, but as Richard has said many times nothing changes fast in this business and I promise we'll remain very disciplined to manage against our targets. A couple of important happenings in the past quarter that we've reported on and I would like to inform you more about and it's really... again, as it relates to service development and these are two new services that we rolled out during the quarter. One with the Accutrac, which is a small records management acquisition that we did last year where in the past, in Q2, we announced a partnership with a FileNet group within IBM to provide prescriptive records management solutions that enable an integrated approach for managing either paper or electronic documents. IBM is a burgeoning partner with us and also provides part of our Image on Demand solution into our Digital Record Center. The second is our most recent acquisition of Animus. Animus provides document workflow solutions that help our customers re-engineer workflow processes that have become real cumbersome without them losing control of that existing processes. So, for example, if you take documents associated with what can typically be bad workflow say, invoices into accounts payable or contracts within the legal department, we can help them take over that process by scanning those documents, indexing the documents, presenting them back to our customers through a web interface and then either preserving the original physical document or destroying it if the business requires. This gives us advantage both in software as a service, and storage as a service and driving recurring revenue and while Animus just joined the Iron Mountain family, we're encouraged by their potential. In general, acquisitions of new service capability is key to our strategy and we did tell you that acquisition activity would be modest this year and we are following through on that, in part because we had a relatively fast pace here in 2007 and I do want to update you that the integration of our three biggest acquisitions ArchivesOne, RMS and Stratify are all going particularly well and we are particularly excited about some of the potentials that we're seeing out of the eDiscovery space with our Stratify acquisition. And you should look for more news to come as they acquire a larger and larger footprint in that very fast-growing space. During the quarter, we also announced the tactical divestiture of one of our businesses. As we add to our service portfolio, we also want to ensure that we're sharply focused on performance management and strategic fit. And in the context of both, actually we made a decision to divest our commodity data product sales business in Q2. This is a small business comprising about 1% of our revenues that’s focused on the sale of commodity products to our customers where there was limited contribution to our profits. So, we really saw this and evaluated as a non-core business and entered into an agreement with another company for them to manage this business where we will receive a royalty on future sales. That is my report on Q2. I want you to know that Iron Mountain is doing well and that the team is committed to a disciplined growth strategy that maximizes our long-term potential while delivering consistently strong annual financial results. I am very pleased with our performance year-to-date and believe that we're on track to delivering against our stated objectives for the remainder of the year. With that, I will turn the call over to Brian for today's financial review. Brian?

Thanks, Bob. Q2 was another solid quarter for Iron Mountain keeping us on track to meet our full year financial goals. We posted strong revenue and OIBDA gains slightly ahead of our forecast. These results reflect solid underlying business performance across our business segments. We will begin today with a review of our Q2 results. We will also review our year-to-date cash flow performance, capital spending trends and debt positions and put these results in the context of our full-year outlook. We will conclude with an update of our 2008 full-year guidance, which has been positively revised today reflecting our solid first half results. We'll also share our outlook for the third quarter. Slide four highlights the key messages from today's review. Iron Mountain delivered strong financial results in Q2 with revenue and OIBDA each growing 15%. We continued to drive strong business performance in a challenging economic environment. This reflects the strength of our business model as well as benefits from a disciplined approach to managing our operations. We posted high revenue gains across all major business units, supported by 9% internal growth, the benefits of our major acquisitions and favorable year-over-year foreign currency movements. OIBDA was supported by solid gains in gross profit, which offset some dilutive impacts from acquisitions completed last year and some carryover impacts from investments initiated in 2007. We also strengthened our balance sheet increasing flexibility and liquidity with the successful refinancing transaction including the sale of $300 million of 8% bonds due 2020 and the redemption of $72 million of 8.25% bonds due 2011. The redemption was completed in early July. As a result of our first half performance we announced positive revisions to our 2008 outlook. We now expect 12% to 13% revenue growth and 11% to 14% comparable OIBDA growth for the year. We remain confident that we are on track towards achieving these full-year financial goals. One item of note before we continue, as mentioned in our press release this morning, we divested ourselves of our commodity product sales business as of June 1st. Accordingly, we're removing the revenues associated with this business from our internal growth calculations for both 2007 and 2008. The impact of this divestiture is reflected in our updated guidance. Now, let's move on to looking at the details of our performance on slide five. Slide five compares results for this quarter to Q2 of 2007. Overall we had another strong revenue quarter supported by balanced growth across our key business segments, which drove the overall increase of 15%. Our largest segment in North American Physical posted a 11% growth overall. Internal revenue growth was 8%. We saw a solid growth in secure shredding supported by continued strength in recycled paper prices and in our data protection business. These gains offset some softness in project-based revenues. Despite these impacts, internal growth in North America is tracking solidly within our target growth range for the year. Our international physical business was up 21% overall. Internal growth was 9% supported by continued strength in our Latin America business and gains in complementary service revenues in our European business. International growth also benefited from select acquisitions that are strengthening our global footprint and from favorable foreign exchange changes, which together added about 12% to revenue gains. Finally, our Digital segment drove strong revenue gains growing 37% overall supported by 16% internal growth. We saw a consistent growth in storage revenues and better than expected performance in data restoration projects, which had been relatively week since the end of 2005. Revenue gains helped drive a solid 17% year-over-year improvement in gross profit. Gross margins were up about 100 basis points for the quarter compared to the same prior-year period supported by improved storage margins reflecting labor and real estate efficiencies as well as benefits from growth in the high-margin services and sustained higher recycled paper pricing. SG&A growth was 20% in the quarter compared to prior-year levels. Higher rates of overhead growth were impacted by two primary factors highlighted on our last conference call. The first involves the integration of recent technology acquisitions including Stratify, which have a relatively higher overhead cost basis as a percentage of revenues. SG&A growth also reflects carry-over impact from investments in security, international sales resources and infrastructure initiated in 2007 as well additional stock option expense related to higher than normal grant activity last year. We expect SG&A growth to continue at higher rates through Q3 and to moderate in the fourth quarter of this year as most of the ramp in acquisition and overhead investment took place in Q4 of 2007. Despite these effects, OIBDA was up 15% for the quarter to a $197 million. Depreciation was $64 million and amortization was $9 million for the quarter. The increase in the amortization was driven primarily by technology acquisitions completed in the second half of 2007. Operating income was $124 million for Q2 2008, up 11% versus the prior year as OIBDA gains were partially offset by increased depreciation and amortization driven by 2007 capital spending in acquisitions. Slide six, breaks down our overall revenue growth. It shows internal growth by major service line as well as the impact of acquisitions in foreign exchange, which added about 4% and 3% respectively to our growth rates for the second quarter. Internal revenue growth for the quarter was 9%, in range of our full-year growth goals. As a reminder, we removed the 2007 and 2008 revenues associated with the divested product sales business from our internal growth calculations. This had no impact on the internal growth rates we reported for Q1. Internal growth was comprised of 8% storage growth and 9% service growth reflecting continued benefits from expansion of less capital intensive, more project based offerings. Core service internal growth improved to 9% in Q2 supported by benefits from higher fuel surcharges. The internal growth rate for complementary services moderated in Q2 as expected. Growth of recycled paper revenues across geographies remains strong supported by year-on-year increases in recycled paper pricing. Offsetting these gains was a slowdown in project activity in the Americas and lower growth in fulfillment services, which are areas more likely to be impacted by economic conditions. Complementary service revenue, which represents nearly 15% of overall revenues can fluctuate over time, given fluctuations in demand and timing for a special project activity and variation of factors such as recycled paper pricing. As noted in our last call, we do expect growth in complementary services to moderate as we work through this year due to comparisons to some large European public sector projects that either completed or winding down. We also expect some continued pressure on more discretionary spending areas in the Americas given the current economic slowdown. Despite these anticipated impacts, we expect that our overall internal growth rates will remain solid through the year and believe that we're on track to deliver against our full year internal growth goals. Moving on with our review of Q2 P&L performance, slide seven reviews our Q2 operating income to net income and EPS results. Q2 results on these fronts were basically as expected although we did experience some discrete impacts, which pressured our reported net income and EPS results for the quarter. As discussed, operating income for the quarter was up 11% to $124 million as OIBDA gains were partially offset by year-on-year increases in depreciation and amortization. D&A grew $13 million versus prior-year levels in Q2 reflecting increased CapEx spending and the impact of our 2007 acquisitions, most notably, ArchivesOne and Stratify, which were completed in May and December 2007 respectively. Our Q2 interest expense was $60 million as expected and in line with Q1. We now expect interest for the full year to be in the range of $240 million to $245 million, including the impact of the recent refinancing activities I spoke of earlier. Other expense was $4 million or $0.01 per share in Q2 primarily reflecting losses related to foreign exchange rate fluctuations as we mark our inter company and third party debt to market. We also recorded approximately $350,000 of debt-extinguishment charges in Q2 related to our due in 2008 debt offering. In the second quarter of 2007, we reported other income of $3 million or $0.01 per share related primarily to foreign currency exchange rate gains and insurance gains. Net income and EPS were $36 million and $0.18 per diluted share respectively, down slightly from the 2007 levels due primarily to a higher effective tax rate in the second quarter compared to the same period last year. As a reminder, we've recorded significant tax benefits on net gains associated with foreign currency rate changes in the second quarter of 2007. This year, our second quarter tax rate before the impact of discrete items was 38%, as forecasted. The impact of discrete of items, including the interest on our tax reserves added three points to our effective tax rate and reduced diluted EPS by about $0.01 per share. We're still estimating our tax rate before discrete items for 2008 to be approximately 38%. After 2008, we expect our tax rate excluding the impact of discrete items, to decrease over time to approximately 36%. Turning to slide eight, let's look at our year-to-date performance. You can see that our Q2 results build on the solid performance we posted in Q1. Overall balance growth across our key businesses and service lines is supporting solid revenue and OIBDA gains and reinforcing our confidence that we're on track towards delivering against our strategic and financial goals this year. Net income for the first half of 2008 was $69 million compared to $74 million for the same period in 2007. The key factors impacting the 2008 results are other income, which was $3 million or $0.01 per diluted share versus $11 million or $0.04 per share in 2007 and a higher effective tax rate, which was 38% this year versus 33% in 2007. Let's now shift to reviewing drivers of our cash flow performance. Slide nine summarizes our capital spending for the quarter. It highlights our year-to-date results compared to the full year 2007 amounts and our current 2008 outlook, which we're reiterating today. Our CapEx for the first half of 2008 was at $137 million including $11 million for real estate. Traditionally, the first half of the year is lighter with respect to CapEx as some projects are scheduled for later in the year and many require a time to plan and source before the significant expenditures are eventually made. We are currently spending to our plan and expect to finish the year within the forecasted range. Let us now move on to slide ten and look at free cash flow for the quarter. Slide ten highlights our year-to-date cash flow performance compared to the same period in 2007. For the first half of 2008, free cash flow before acquisitions and discretionary investments in real estate was $20 million. The year-on-year decrease in cash flow reflects the payment in Q1 2008 of the unusually large 2007 year-end CapEx accrual balance of $60 million and $30 million increase in working capital usage. The working capital increase was due primarily to increased AR, increased incentive compensation payments in 2008 and the timing of payroll check run [ph]. Keep in mind our free cash flow was best looked at on a full-year basis as the timing of certain cash events is not consistent through the year. For example, the first quarter, historically our lowest cash flow quarter, was impacted by the 2007 CapEx accrual and the payment of annual bonuses. For 2008, we expect free cash flow before acquisitions and discretionary investments in real estate to be approximately $25 million to $75 million. As noted in our last call, 2008 free cash flow is impacted by the 2007 CapEx accrual I just spoke of being paid in Q1. Now, let's turn to slide 11 to review over debt statistics. In terms of our debt portfolio, we ended Q2 2008 in a strong position as we can see in the slide. Our weighted average interest rate is 7.2% and we are 81% fixed. Consolidated leverage is now 4.4 times within our target range of 4 to 5 times of OIBDA. Maturity is now at 7.8 years with no meaningful repayment obligations until 2012. As you know, we successfully issued 300 million of 8% senior subordinated notes due 2020. We used the net proceeds to pay down our senior credit facility. We also redeemed the remaining $72 million of outstanding 8.25% notes due in 2011 in a transaction that was completed in early July. This is the regular term out of our short-term debt consistent with past practice. Rates may come down considerably over the preceding several months and were reasonable compared to our long-term average. Based on our ability to execute a transaction at attractive rates and our expectations of continued uncertainty in the credit markets, we felt that it was the right time for this refinancing. Our ability to issue debt at attractive rates in an uncertain credit market demonstrates the strength of the Iron Mountain business model. As a result of these activities, our liquidity position remains strong. As of June 30th, 2008, we had nearly $715 million of cash at availability under our revolving credit facility. Now, let's move ahead to slide 12 to discuss our 2008 guidance. Turning to slide 12, based on our solid start to the year, we're announcing positive revisions to our full-year outlook. Our full-year revenue outlook is now $3.15 billion to $3.19 billion or growth of 12% to 13%. We are now targeting full-year operating income of $478 million to $498 million. This would imply an OIBDA range of $773 million to $793 million for the year or growth of 11% to 14% on a comparable basis, excluding gains and losses on asset write-downs. We are maintaining our full-year CapEx forecast of $440 million to $480 million. At midpoint performance, this could equate to a modest reduction in capital spending as a percent of sales in 2008 building on our 2007 progress. Our expectations for Q3 performance are shown here as well, which implies revenue growth of 8% to 10% and 4% to 9% comparable OIBDA growth. Note that our prior-year Q2 results were benefited from high levels of service growth, which resulted in 12% internal growth and strong OIBDA margin flow through. Our growth outlook for Q3 of this year reflects comparisons to these strong results. We'll continue to work through higher levels of cost growth in Q3 as well driven by acquisition integration and carryover impacts from investments initiated in 2007. As noted, we expect these impacts to moderate in the fourth quarter. In summary, we had a solid first half of the year. We are driving solid growth across our business and we're confident that we're on track towards delivering our full-year financial objectives. Thanks, and we'll now open the phones to take your questions. Question and Answer

[Operator Instructions]. Your first question comes from the line of Kevin McVeigh with Credit Suisse.

Thank you. Hi, I wonder if you could give us a sense of... very nice job on the gross margins in the second quarter. How do you see that gross margins playing out in the second half of the year relative to OIBDA overall?

Yes, we're continuing to target solid gross margins in 2008. We're seeing things... factors such as real estate and productivity gains helping us, these were the things we expect when we built our plans this year. And we're also currently seeing benefits from paper and higher margin service growth. Those are factors that will moderate later this year but our outlook includes sustaining solid gross margins.

Great. And if you could give us a sense of in terms of recycled paper prices, where they are currently and what do you have in the outlook in the second half of the year?

Yes, we're... the recycled paper market has flattened in recent months, it's actually down a bit from some of the peaks we saw in February and March. It would still... it can be up year-on-year at current rate to the back half of the year. We think that the underlying factors that have supported the higher levels of paper pricing, which are really driven by international demand are still there. As you know, this isn't an easy market to forecast, but we think we'll see sustained solid paper rates. But if you want to reinforce that this is the factor we've highlighted several times in the past. These things can fluctuate, it can have an impact on our results with the margin and were basically embedded in our outlook is in expectation that will sustain in the similar range. So, but this is something we'll keep an eye on.

And we are being particularly careful, Kevin, to moderate overhead growth as we go through the balance of the year, something that we're just... we're very, very careful about.

Okay. If I could just one more question if you don't mind. The core services really, sequentially came up nicely internally. Can you talk about destructions a little bit and how the surcharges impacted that?

Yes. Two different...two different topics that you have raised there, say the... we highlighted in the… our last call where we saw a little softness on core service activity that was down a bit with… in areas like destructions because we had higher activities late last year. And that's pretty much the same, I would say our overall core service activity is a little below what we would see normally. And that's not unexpected given some of the things that highlighted [inaudible] last year.

There is a cost associated with destructions to the people who are pausing on now because they face their own overhead pressure. And while they saw the usefulness of during that maybe even just a matter of months ago, they are now holding on that project revenue.

But, the second topic which you picked up on we did highlight in the call was the improvement kind of quarter-on-quarter because the growth rate went up a couple... 200 basis points was... it was helped by higher fuel surcharges. Obviously, that is offsetting some of the higher energy costs that we see. So, net net it really helps us to manage energy impacts and keep that effect at a minimal level. It's not intended to be a profit driver for the company but it does benefit us in terms of our core service growth rate.

Great. Thank you very much.

Your next question comes from the line of Andrew Steinerman with JP Morgan.

Hi, gentlemen. I'm trying to look at EBITDA margins sequentially. They went from 28... $23.9 to $25.5 in the quarter first quarter versus second quarter this year, a 160 basis point increase. If you could break out for us, what do you think the drivers are there, and specifically [ph] one, what's a normal seasonal pickup, I know first quarter is the low quarter of the year usually on margin? Two, kind of less drag from past acquisitions and three kind of just maybe less incremental investment in our infrastructure?

If I can just start with, Andrew, I just wanted... we have been... we've tried to being very careful but this is not how we manage the business right. We don't…

Right.

So, with that in mind, we can get into the specific answers.

Yes. I think Andrew one of the things, I'm trying to get at the gist of your question. I mean I do think we look at our business more year-on-year rather than quarter-to-quarter.

Right.

I would say year-on-year, we made improved progress on gross margin enhancements, which was driven by several things. Actually, it included the solid productivity gains in the storage front. We had higher levels of service margin growth, it's a high growth in areas where we have high service margins, areas like Stratify like our Digital business and we have... those factors are helping and continued benefit from the recycled paper pricing, but I think those factors were probably sequentially a bit better for us. I think we're seeing some moderation in the overhead cost impacts. We'll continue to see that as we work through the year. It's going to be more a Q4 benefit than a Q3 benefit. And those are related to two kind of key drivers and I think both of those factors are things that we hope to sustain. So, if you look at our outlook for the back half of the year, in implies that we will have improvement in year-on-year margins assuming our mix comes in as we expect and that reflects sustaining that good gross margin performance and maintaining good discipline overhead cost growth. So, we look forward to continue to force progress on that front. The one thing I would caution you on is, and this was something Richard reinforced in the last call is kind of taking the ruler out and looking at a quarter and drawing a line off of that. I mean, we do have seasonality impacts in this business, we do manage this business on an annual basis and our discussion day is just focused on back half of the year. We haven't given any outlook or insight into next year.

Right, right. That's why I asked the question originally sequentially to account for seasonality but it sounds like when you are answering year-over-year and probably was some help seasonally , sequentially plus the other factors that you just attributed year-over-year also helping this sequential progress as well.

That's fair. And Q1 historically is our lower-margin quarter just given the higher relative energy costs and just...

That's right.

[inaudible]

Okay. Thank you very much.

Thanks, Andrew

Your next question comes from the line of Scott Schneeberger with Oppenheimer.

Hi. Thanks, good morning.

Good morning.

Just following up right there on energy and some question on pricing, obviously you're getting the fuel surcharges and that's contributing to the growth. The impact of higher energy cost, is that, I would assume that’s hitting more on the gross margin than it is on SG&A. Could you just confirm that and also discuss how your fuel surcharges work? How much of your client base is on that for what term of a contract and are you hedging fuel at all?

Well, Scott, the net of it all, it's a limited impact on our financial results. We don't hedge on fuel, it's about 3% of our total costs are energy related… 3% of revenue, sorry... thank you, 1.5% of which are transportation related. We're able to pass most of that through, if not all that through, but in some cases we have contracts where it doesn't go through other cases we do. Our buildings are very energy efficient and relatively quiet from an energy consumption perspective but the net of it is that we hear a lot of questions on this front and it doesn't have material impact on our financial results [inaudible] across.

Okay, thanks. Kind of shifting gears a bit. I think you'd have alluded when you were discussing Stratify and I mean I got the sense that you may be looking to expand or potentially do acquisitions in that space to pad. Was my inference correct and are you going to be thinking about doing large things or more of that tuck-in [ph] in the nature?

Scott, I have a great confidence in the team with Stratify and in the business that this builds to the extent that you will find that we generally partner with folks before we acquire them. So you can, generally speaking, see those things coming. We've partnered with Connected and LiveVault long before we locked them. And I think fundamentally, we've great faith in that team, nothing big coming but we are always looking for potential candidates to partner with and that can act as a precursor to acquisition.

Scott I think in Bob's comment, he was alluding more to a... we feel really good about the team and have some pending customer wins that we look forward to talking abut. It wasn't intended to be a reference to acquisition.

Yes. You'll see them expand their market presence.

[inaudible] platform we've got and the discovery with the Stratify team.

It's a great, great team.

Excellent, thanks. Jumping back real quick on... as far as what I meant to follow-up with on the surcharges as well was... I think pricing you had alluded this year that you're looking to get maybe a 2% increase. Any update there and how you look at that in combination with the surcharge?

We don't look at the surcharges, what we would think of is pricing and I think that's a relationship we have with our customers where we are trying to mitigate offset costs. And I think our ongoing service relationships looking at our pricing we had talked about improving our trend on that front. And we're making good progress. We think we are on track to achieve. The metric we typically talk to is the U.S. hard copies, storage price and how that's increased over time. And we are on track towards that 2% level, which we think is consistent with the value that we are delivering to our customers. And we feel good about the progress we're making there.

Great. Thanks. And then finally, you announced recently the collaboration with IBM and partnership with HP, is this something… I mean, are we seeing the start of a trend here of something you're going to be doing a lot more, just partnerships? And could you give us an update on how those are going?

Sure. So we feel very good about our relationship with HP for medical image archiving and the one that we just announced with Accutrac. I think you should expect to see more of it. We have a great opportunity to move our technology through others P&Ls and to move their technology integrated with ours… through ours. It's a valuation of the brand that we have in the market, the trust that we've created with our customers and the technology that we have acquired, through our internal bills as well as through the teams and technology required at Stratify [inaudible] Connected, LiveVault. These are technologies that are unique and differentiated in the market where there is sustainable competitive advantage and interest from some of the largest players and technology today. So, I would expect our… the amount of business that we are driving through alternative channels to increase slowly over time. These things to take… these partnerships take longer than everybody expects because we do it from a recurring revenue prospective. They have a much slower build but a much longer duration.

Great. Thanks so much.

Thank you.

Your next question comes from the line of David Gold with Sidoti.

Brian, I wanted to follow up a little bit on your comments about SG&A moderating in the fourth quarter. Should I understand that as a function basically some of the say more discretionary items like security spending pullback or spending telling off on that or are you more saying that we anniversaried the increase in expense last year so it's going to be more a function of that?

It is going back to what some of the drivers have been year-to-date, the bigger driver was actually the impact of some of the technology acquisitions that we did last year and ran that into our cost base and Stratify was completed in December of last year and we'll start to see moderating impact from that factor. We did step up the investment in the areas that we had highlighted in terms of security and international sales resources. We're still investing in those areas. We just don't have to step up. We have been, as Bob mentioned, been very mindful about prioritizing our investments in the current climate and we are balancing investments against our strategy with making sure that they are calibrated against our top line growth. So those are factors that are contributing. One thing I would highlight is, as you recall in our fourth quarter call last year we had, every year we have a level of drew ups and accruals and things of that nature at year-end time and last year, we had a number of things that kind of went in one direction that impacted us negatively to the tune of about $5 million. Keep in mind, we are not expecting that. We always are going to have some variation, but we are kind of expecting normal activity this year. So that's a $5 million kind of lapping benefit in terms of cost growth that's built into our Q4 expectations. So it is all of those factors combined in.

Okay. And some of the discretionaries, probably a bad word, but the more discretionary items there are like, let's say, securing some of ones that you have marked out, were those more front-end loaded or they fairly evenly spread out?

It is a pretty even spread, it’s something that we plan over a long period of time if you are going to be fortifying transportation fleet or training an employee base or facility infrastructures, it’s planned over a long period of time. So it is pretty smooth and from our perspective, we have a series of core values, David, inside of Iron Mountain and consider secured to be job one, but it's not a discretionary expense from our perspective. We don't view ourselves vis-à-vis our competition, we view ourselves vis-à-vis our value proposition. And that’s an area that we will continue to invest although to the untrained it could appear to be over investing but we are about the long-term preservation and security and storage of our customers’ data. So, that will be an area that we will perpetually invest in.

Sure. Much appreciated, Bob. And then just, one other, can you remind us what the '07 revenue contribution was from the product sales business that were divesting?

It was about 1% of our revenues last year since a relatively small business and had pretty limited profit contribution. So it was, as Bob mentioned, something that wasn't as larger business. As you look balance here in our growth rate, keep in mind that's factored into how we think about gross. So that will offset much of the acquisition benefits that we have seen, but it was a relatively small business and shouldn't have a big impact on our bottom line.

Terrific. Thank you, both.

Thanks, David.

Your next question comes from the line of Michel Morin with Merrill Lynch.

Yes, this is David Ribenmine [ph] for Michel. Can you... just a question on the impact of higher gross margin acquisitions and then the divestiture of the lower gross margin data products business. Could you sort of quantify that impact... that net impact on gross margins?

The... I am just trying to follow your... the benefit of technology acquisition growth and the impacts of the product sales fees.

Right. So you devastated a relatively lower gross margin business and you also acquired relatively higher gross margin businesses as I'm just trying to get the impact of those two effects?

Yes, we don't get down to fine tuning the numbers at that level, but I would say that they are moving in different directions and are... they are one of the bigger factors impacting our gross margin performance in the quarter. So that helps in the context, it was... there is some impact out there but it wasn't highlighted, it’s one of the bigger factors.

Okay. And then, can you remind us what percentage of your revenues are in the complementary services area?

It's overall for our company, annually it's about 15% of our total revenues.

Okay. All right. Thank you very much.

You're welcome.

Your next question comes from line of Franco Turrinelli with William Blair.

Good morning, Franco.

Good morning, guys. Actually questions for Brian. Brian I just wanted to see if we can clarify, one of the previous questions has concerned me a little bit. There was an implication that the fuel surcharges had a material impact on the growth of our services and I wonder if you could just give us a little bit more of clarity on that?

It's… what I was referring to core service growth and the question was seemed to have improved from Q1 to Q2. And we did hire... it was 7% in Q1 and 9% in Q2, Franco, and just highlighted at the margin I think that's [inaudible] on that particular service line is increased fuel surcharges. And I just want to highlight that that's just have some impact at the margin on things like core service growth, it doesn't really have... has not had a significant profit impact because it really just offsets higher energy costs.

Great. Thank you, congratulations.

Thank you.

[Operator Instructions]. Your next question comes from the line of David Rainey with Akre Capital.

Could you all just remind us, I was looking on slide nine and down, how do you all think about maintenance CapEx spent to maintain the earnings power of your assets versus growth CapEx? Is it caption on the slide or is it additional information you could share?

We don't disclose that in our regular reporting. We do make reference in our SEC filings that we estimate overall as a company that about 15% of our capital spending over time, there has been what we categorize as more maintenance oriented. If you think about the nature of our business in a way, the capital intensity is typically about adding physical and now digital storage capacity as we had records, physical records or bits and bytes that we were storing. So, the bulk of our capital investments are more growth oriented and what we would characterize as more maintenance oriented capital is a smaller percentage of the total. It is important to understand in terms of our business, because we're a growth business and because we're deploying growth capital that limits to a degree our cash flow in the near term, but we believe that over the long-term, given that the maintenance capital is relatively low on our business that it... our business had very attractive long-term cash flow characteristics.

Okay. So then 15% of your CapEx guidance for the year would be about $70 million?

You know that math would work, we don't get that specific and how we talk about guidance, it's more directional, an estimate of what percentage of our spending over a period of time has been maintenance in nature.

Okay. And then... excuse me, I've got a follow-up and that is across your different lines of business, how do you all look internally at forecasting rates of return on growth in Digital, core storage services versus the potential for share repurchases? And I don't ask this so much in the context of when are you going buy stock in the third quarter or the fourth quarter. I'm just thinking about it in the context of everyday management has a decision whether or not they pay dividend buying shares, pay down debt, sit on their cash or invest in growth assets. And so I'm just curious as to how you all look at that framework to work to optimize the business long-term?

Just as a principle, you should know that we have... we're very focusing just on our management of capital, we control our capital decisions centrally. As I highlighted... we highlighted last year in our Investor Day discussion, we... our financial objectives imply in return on incremental invested capital of 15% to 20% and we believe we have very attractive opportunities to invest in our business and deploy capital in that front and we look at those type of metrics as we make capital decisions. We did highlight that overtime given our... the profile of our business and objectives and our ability to attract investment that we may have the opportunity for funds beyond what's required to invest in attractive opportunities in our business and have not made any decisions on that front relative to deploying those funds. We did highlight share repurchases and dividends as options, but we don't have any news on that front at this time.

And that’s a finance discussion that happens between a few of us and with the Board of Directors from a day-to-day prospective, we're really focused on how we are driving returns with the growth out of our core business and juxtaposing that against and clearing that with investments that we can make in international expansion and expanding our service base. That's the strategy that operating team focuses on a day-to-day basis. So, it's really not our day-to-day business to talk about. Returning cash to shareholders, that's a very limited discussion that's controlled centrally.

And okay. Just to follow-up, when you talk about 15% to 20% incremental returns on invested capital, are you discussing that on a levered or unlevered basis taxed or untaxed, how do you all think about that?

That's a metric that's really looking at the incremental OIBDA we expect to generate for the capital that we are deploying. It's a pre-tax number and it's unlevered.

Thank you.

David, thank you for your question. I do very much appreciate all of your support. We are at the end of our hour. Thanks for your support of Iron Mountain. To the extent that you can enjoy any of your summer that's remaining, please do. And we'll look forward to seeing you on October 8 in New York City at the Grand Hyat Hotel for our Annual Investor Day and again on October 30th for our next earnings call. Thank you all and have a good day.

This concludes today's Iron Mountain second quarter 2008 earnings conference call. You may now disconnect.