This post is the second in an occasional series where we will review our previous analysis – the good, the bad and the ugly – to discern what we are doing right and what we can improve.
After the self-flagellation of the last post, I decided to look at a stock that has done decidedly better, Amerco (UHAL, Financial). UHAL is up 100.99% since our post.
To quickly review the background, UHAL’s principal line of business is the renting of do-it-yourself moving equipment to consumers. This largely consists of trucks and vans. UHAL also leases self-storage space to consumers.
My thesis was fairly straightforward. UHAL had developed a moat by creating a network of trucks all over North America to serve the intra-city moving market. Further, it poured capex into widening the moat each year by buying additional trucks, creating more self-storage space and expanding its network of dealers. This infrastructure of trucks, dealers and storage space was very expensive to replicate with no guarantee of success. Indeed, UHAL’s main competitor, Budget, was fleeing the industry. Therefore it seemed highly likely that UHAL brand orange trucks would be visible around North America in 2023 and beyond.
Yet, I did not give the company a full-throated endorsement. Unlike CONN, UHAL was an error of omission rather than commission. What can I learn from this?
LESSON #1 – Management Has Performed Better Than Expected
One of my chief concerns was management. There were a couple of red flags that gave me pause. First, the founding family, the Schoens, had been embroiled in a soap opera-like battle for control of the company. Also, the company engaged in a number of significant transactions with Schoen-controlled companies. Yet, management has performed better than expected. What did I overlook?
Clearly Stated Principles
In the 2004 Annual Report, the Chairman laid out seven guiding principles for managing the company that he called “AMERCO’s Shareholder Value Proposition”:
It is our intent to be a medium-size company with an entrepreneurial, aggressive management team, relatively immune to the potholes of corporate bureaucracy. Our plans include the following:
- Operating in a specialty niche, where our success is dependent more on how we treat our customers than on competitive or market condition
- Developing a self-funding balance sheet. Expand by using our own profits.
- Maintaining substantial insider ownership. This includes Shoen interests, ESOP and individual ownership by directors, employees, dealers and vendors.
- Continuing with a North American orientation. Remain relatively insulated from political changes and currency valuations.
- Maintaining constructive labor relations. Management free to make decisions independent of outside groups. Encourage a coincidence of interest between ownership, management, operative U-Haul System members and dealers.
- Maintaining a reasonable price/earnings ratio on our common stock. Emphasize the strength of the company, not the strength of the stock price.
- Employing people who are high in integrity. Successful companies are composed of people with integrity at all levels of the company
These principles were cited again in the 2015 Annual Report. This approach indicates that management understands the nature of their moat and will continue to operate in a manner consistent with expanding that moat. Further, I like managements that explicitly state their guiding principles and stick to them. It shows self-confidence and provides a clear yardstick for measuring performance.
The Buffett Test
To evaluate management, particularly in capital-intensive industries, I often use a metric introduced by Warren Buffett (Trades, Portfolio). Buffett wrote in the 2009 version of the Berkshire Hathaway Owner’s Manual that “(w)e test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.” He then went on to discuss the specific criteria employed: “ (1) during the period did our book-value gain exceed the performance of the S&P; and (2) did our stock consistently sell at a premium to book, meaning that every $1 of retained earnings was always worth more than $1? If these tests are met, retaining earnings has made sense.”
Since the 2010 restructuring, UHAL management fares well under this test. Indeed, only the tough years of 2007 and 2008 are below par.
Source: Company filings via Sentieo.com
Related Party Transactions
There are six related entities UHAL does business with. These entities are all controlled directly or indirectly by members of the Schoen family, the descendants of the company’s founder. The Shoens control most of the stock of UHAL and Edward Shoen is the chairman and president of the company.
UHAL manages self-storage property owned or leased by these entities. Some of these self-storage facilities were acquired with loans by UHAL.
UHAL also leases space from some of these entities. Some of these entities act as independent UHAL dealers. Some of these companies also owe UHAL money under loan agreements.
These transactions are not insignificant. Related party revenues for fiscal 2016, 2015 and 2014, net of eliminations, were $32.6 million, $36.2 million and $36.9 million, respectively.
Related party costs and expenses for fiscal 2016, 2015, and 2014, net of eliminations, were $57.4 million, $54.7 million and $52.6 million, respectively.
While I still don’t like related party transactions, I cannot point to any actions taken by management that were to the detriment of shareholders. Perhaps it is time to give them the benefit of the doubt.
LESSON #2 – The Quality of the Self-Storage Business Was Overlooked
I also underrated the quality of the self-storage business. I saw it as a weak business with lots of competition. Specific problems I identified included:
- Limited barriers to building competing supply. Construction and maintenance costs are low. Often, the facility can be placed on less expensive real estate.
- Fragmented Industry. Consistent with the lower barriers to entry, the self-storage industry is highly fragmented. The biggest player, Public Storage (PSA) has just a 5% market share. Thus, no single company has much bargaining power over consumers.
- Pressure to discount. In a high fixed cost business like self-storage, there is more pressure to discount. Because the incremental cost of renting out additional storage space is minimal, it is tempting to offer discounts to avoid the vacancy. A similar dynamic is one of the factors that have plagued the airline industry. Warren Buffett (Trades, Portfolio) described the situation at the 2013 Berkshire Hathaway annual meeting: “In the airline industry there is very low incremental cost per seat, but very high fixed costs. The temptation to sell the last seat is very high, and it is hard to distinguish between which is the last seat and the other seats.”
- Commoditized Service. Despite attempts to offer amenities like temperature control, heightened security and easier access, there is little differentiation between self-storage facilities.
For this reasons, I dismissed UHAL’s self-storage business. Yet, revenue has grown much faster in the past 5 years for the self-storage business then the business as a whole – 17% CAGR versus a 7% CAGR. By looking at the company on a segment basis, we can see just how profitable the self-storage segment is. In fact, based on my calculations, self-storage’s 70% EBIT margins masks much lower margins in the moving equipment rental business.
Why is Self-Storage Such a Great Business?
The following are the key characteristics that make self-storage a great business:
- Demand seems to be growing – Over the 15 year period from 1995 to 2011, supply doubled, going from 3.31 square feet per capita to 7.25 square feet per capita. By 2014, it was up to 8.32 square feet per capita.
- Sticky – Once in place, customers don’t leave. The average stay is 12-18 months.
- Constraints on supply –Development of new self-storage facilities is more difficult than it appears for several reasons. First, land use, zoning, environmental and other regulatory requirements slow construction. Municipalities prefer commercial buildings that will house workers rather than junk. Second, developers encouner difficulty in getting financing. Since the Financial Crisis, there is a general tightness in small business lending plus banks are more interested in lending to businesses with ongoing operations than to firms with hopes of revenue streams from projected rentals.
- Pricing Power – Inelasticity of demand drives frequent rent increases.
- Low Maintenance Costs – The low cost of maintaining self-storage facilities drives high margins.
- Economies of Scale – Fixed costs are high relative to variable costs. The costs required to run a self-storage location don’t increase much, if at all, with each new tenant. There are further benefits to scale as a company opens a number of facilities in a given metropolitan area.
- Low Breakeven Point – High fixed costs and high margins combine to create very low breakeven occupancy rates for self-storage facilities. A 2013 study found the breakeven occupancy rate was 40-45% as compared to 60% or more for apartment buildings.
- Nearly Recession-Proof – While there is some economic sensitivity, the customer base tends to be driven by life cycle changes (e.g. marriage, divorce, death, renovation, relocation, summer vacation, military service) rather than the business cycle.
- Synergies – UHAL also benefits from unique synergies amongst its business segments. There is a natural tie-in between the self-storage business and the moving business.
VALUATION
The company is currently valued at a sub-15 P/E and 10 EV/EBIT – an attractive valuation for a wide moat company. The problem is that the company is capital intensive. Even using management’s estimate of $350 million of maintenance capex per year, the company converted just 92% of accounting earnings to free cash in fiscal 2016. Other years have been much worse. The current post-tax, post-interest FCF yield is 7%.
I would like to see at least 8% FCF growth per year over the next 10 years in Moving and Storage. To do so, I have made the following assumptions:
Source: Company filings via Sentieo.com
While these assumptions are conservative relative to historical norms, I have a healthy skepticism regarding my ability to project future demand for self-storage services and DIY moving equipment rentals. Specifically, under these assumptions, by 2025 UHAL will have 285,482 trucks up from 139,000 and 62,123 square feet of storage up from 23,951. Can the market really support this?
The self-storage industry, in particular, has benefitted from accelerated growth. As stated above, per capita square feet of self-storage space jumped from 3.31 square feet in 1995 to 8.32 square feet in 2014. Over this period, the industry benefitted from an increasing acceptance of renting additional storage outside of the primary residence.
The growth trend has accelerated over the past 6 years. Since 2010, employment levels, the housing market, and mobility of the population have all improved. Further, supply has been constrained, as stated earlier.
Obviously, these favorable conditions cannot last forever. In fact, the self-storage industry has in the past experienced overbuilding in response to perceived increases in demand. There are conflicting signals as to exactly where the self-storage industry is in the current capital cycle.
- Capital is entering the market. Cap rates are dropping as REITs bid up prices for existing facilities.
- Construction spending is up but still below demand. CBRE estimates 600 new facilities in 2016 and 900 in 2017. However, the natural refresh rate is 1% of total stock. Therefore, an average year should have about 500 new starts. But, that hasn’t happened in over 10 years.
- Rents and occupancy are both up suggesting that supply still has not caught up with demand.
Source: Form S-11 National Storage Affiliates Trust
Beyond these considerations, how much self-storage space can the US really support? Are we heading towards 10 square feet per person? 16? 20? Can it continue to grow much faster than the population as a whole? I have no idea what the limits are.
On the truck side, the assumptions seem more reasonable. For one thing, as discussed in the original post, Budget has reduced their trucks by 6,000 since 2010 and will continue to do so. So, some of UHAL’s expansion will be simply filling the void left by Budget’s retreat. Similarly, moving rates have still not normalized since the Great Recession. Yet, UHAL truck rentals have continued to climb as this chart shows:
It seems reasonable to assume that, as moves normalize, demand for trucks will increase as well.
A second issue is whether the 2016 margins in the Moving segment are sustainable. One reason for the increase is simply a re-categorization of expense. Lease expense decreased $30.0 million as a result of a shift in financing new equipment on the balance sheet versus through operating leases. So, this expense now shows up in my owner’s earnings calculation rather than my segmented financials. Beyond that, the company is seeing the benefit of economies of scale as expenses grow slower than revenue. Further, for the reasons described elsewhere, UHAL is insulated from competition which should protect their margins.
On the other hand, I have assumed no benefit from price increases. Both revenue per truck and revenue per square foot of storage space have grown much slower than GDP over the past 10 years. That seems unlikely to continue. In particular, increasing occupancy rates in storage suggest that the company has room to increase prices before it begins to tamp down demand. However, the company says it struggles to pass on expense increases to truck renters. For example, on the Q1 2017 call, management stated: “We are reporting a drop in profitability for the quarter year-over-year. Rental truck cost increases put through by Ford and General Motors was a big driver of the decline. U-Haul’s cost of acquisition went up, and we have not yet got the customer to be willing to absorb the increases. Of course, we’re continuing to work on this.” (emphasis added)
CONCLUSION
Thus, while I underestimated the quality of the business in the original post, the somewhat aggressive growth rates embedded in the current valuation coninue to make it difficult to acquire shares.
