sss report

Porter’s 5 Forces

CFA Institute Research Challenge

January 11, 2015

University at Buffalo Student Research This report is published for educational purposes only by students competing in The CFA Institute Research Challenge.

Ticker – NYSE: SSS Recommendation – Sell Sector – Financial Industry – Industrial REITCurrent Price: $91.09 (1/11/2015) Price Target: $83.09 (8.79% Decrease)

Numbers in millions except per share items. Source: Capital IQ and Team Analysis

Highlights

Fragmented Industry Ripe for ConsolidationThe self-storage industry is surprisingly fragmented for an industry where economies of scope are not really at play and scale certainly is. Less than 15% of the industry is controlled by the 10 largest companies and less than 22% by the 100 largest companies. Most self-storage properties are still owned by small, private owner-operators that cannot operate at the same profitability levels as the large firms like Sovran. The industry is ripe for consolidation and Sovran will continue to play a major role in this transition.

Competitive AdvantagesSovran has a competitive advantage over most of the self-storage industry due to its scale as the fifth largest firm in the industry. It is also advantaged due to its universal customer care center and advanced revenue management system.

Seasoned ManagementSovran’s Chairman, CEO, and COO are all founders of the company with ~30 years of self-storage industry experience apiece. The entire C-Suite has been with the company 15+ years. We believe management is thoroughly candid and competent.

2011 2012 2013 2014E 2015E 2016E 2017E 2018ERevenue 202.7 234.1 273.5 317 358.5 390.7 422.5 451.2EBITDA 100.7 120.2 146.3 161.1 194.7 213.9 233 250.8FFO/Share 2.37 3.24 3.79 3.89 4.43 4.41 4.55 4.76AFFO/Share 1.95 2.82 3.38 3.49 4.03 4.02 4.16 4.37NOI/Share 4.69 5.3 5.89 6.35 6.77 6.81 7.02 7.29Rentable Square Feet 28.94 31.19 32.36 34.5 36.57 38.58 40.51 41.73Dividends/Share 1.8 1.8 2.02 2.72 3 3.34 3.46 3.63

Sovran Self Storage, Inc.

Source: Team Analysis

Refer to the appendix for a full analysis

*Note that a high number means a better competitive positioning for the category


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Industry Profitability PeakingOccupancy rates and REVPAF in the self-storage industry have consistently improved since the financial crisis and are at all-time highs. The Self-Storage Almanac estimates that industry supply will finish 2015 up just 8% from 2010 despite ultra-low interest rates and robust demand over the same period. A wave of new developments is about 2 years from completion and outside capital is beginning to take notice of the industry’s prospects and flow in.

Interest Rates Set to Rise and Pull Cap Rates AlongInterest rates sit at a 75-year low. The 10-year Treasury note yields less than 2%. Continued economic improvement should bring interest rates off their low as Sovran’s management, industry analysts, and most investment professionals for that matter, have expected for several years now. This should directly affect all asset classes up the yield curve, including real estate capitalization rates.

Business Description

Business OverviewSovran Self Storage (NYSE:SSS), a real estate investment trust (REIT), was incorporated in Williamsville, NY in 1982. It opened its first facility in 1985 and held its initial public offering in June 1995. Sovran acquires, owns, and manages self-storage properties that operate under the name “Uncle Bob’s Self Storage.” Sovran has 1268 employees and operates 506 self-storage facilities in 25 states.

Rental Revenue A large portion of Sovran’s revenue is rent received from customers for the use of its storage units. Rent revenue should be about 92% of total revenue for 2014. This is in line with legislation stipulating that a REIT must derive at least 90% of its income from rental income. Sovran currently has 503 self-storage properties in 25 states under the name “Uncle Bob’s Self Storage.” Sovran is a 20% owner in 28 properties under Sovran HHF Storage Holdings LLC, 15% owner in 30 properties under Sovran HHF Storage Holdings II LLC, nonowner on 17 properties it manages, and lessee on 4 properties outside of its main line of business. Approximately 37% of the company's revenue is from properties in Florida and Texas. Other RevenueApproximately 8% of Sovran revenue is derived from management fees on properties they do not wholly own.

Source: Company Documents


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Ancillary Income Additional sources of revenue are the rental of trucks to non-customers and existing customers. The company also sells/rents moving dollies, blankets, boxes, tape, locks, and other moving/storage-related products. Sovran Self Storage also earns commission on rental insurance made available through a third party carrier. Incidental income is earned from billboards and cell towers. Operations Sovran daily operations include a call center with 45 trained sales representatives who handle over 30,000 inquiries each month and a peak volume of 42,000 calls per month. Marketing Initiative Sovran deploys an aggressive internet strategy which enables customers to receive real-time pricing, online transactions and reservations, and mobile software. Currently 40% of traffic is via mobile advertising while smaller fragmented companies rely on yellow pages and less complex applications. Growth Using Acquisitions In 2014 SSS committed $800 million to acquire 124 new stores. Management focuses on quality locations and are willing to upgrade assets with climate control and modernization. A large 70% of the firm’s rental location has the ability to be upgraded and these units will command a 20% pricing premium driving growth. Sovran is also willing to sell non-performing assets that had been acquired as part of a portfolio of stores. Management StrategyThe current strategy by management is to avoid major coastal markets. SSS is looking for 2nd tier markets, such as Charlotte, Houston, and Dallas which carry more attractive valuations and profit opportunities. Industry Overview

Self-Storage Industry Overview Self-storage companies allow those with limited space the ability to store away thing they do not need immediately, but in many cases are unable to bring themselves to throw out. Self-Storage has grown rapidly over the past years and around 1 in 10 American households use self-storage facilities. Key Economic Drivers There are a few factors that influence the self-storage business on an economic level. First, as people collect more things that they are not able to consume and are not willing to get rid of they use

Source: Sovran Self Storage Quarterly


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the services provided by businesses in the self-storage industry. As people continue to collect things throughout all seasons of the year, these services are required at all times in the locations where facilities are provided. Important to note, the recent recession only impacted the self-storage sector slightly. This is due to the reason that many individuals who were displaced from their households into smaller living places with more affordable costs, such as apartments still needed space to hold their excess items that were originally in their households. Second, due to the short time period in which a rental contract covers, people are still reluctant to spend time on getting rid of the things they store in the storage facilities; therefore many of the things that were placed in storage stay in the facilities for long periods of time. Self-Storage Facilities Self-storage facilities are able to be classified as Class A, Class B and Class C properties. These play a role in competitive factors because the metrics that separate the three classes from each other reflect varying amounts of risk and return. The varying classes are graded based off a combination of location and physical characteristics. Class A locations are located in prime locations with easy visibility and ample drive-by traffic. The class A facilities are relatively young; having been built within the last 15 years. These facilities are well maintained and include an array of features including climate control, security and automated access control. Second, Class B facilities, while being located in less desirable locations than Class A sites, are still in good locations with a modest amount of visibility and drive-by traffic. Class B sites will typically be older than class A and will typically have good security. They are not always as visibly appealing as the Class A sites, but should be in good working condition. Lastly, Class C facilities are typically 20 years old or older and are not in high demand locations. Class C sites often are in of need renovation and typically lack the newer security features available at the newer Class A and Class B sites. In many instances the locations of Class C facilities will be in areas with very little visibility and little drive-by traffic. As such, Class C facilities are much less expensive and are often marketed to those customers who need to store their items using a less expensive method and for whom price considerations are primary.

Sources: Company documents, Green Street Advisors, Seeking Alpha

*PSA’s performance is used as a representation for the self-storage industry since historical data is limited

Sources: Company documents, Self Storage Association, Green Street Advisors, Seeking Alpha, Statisticbrain.com. As of 6/30/2014.

*Number of facilities with ownership interest**Per Net Rentable Square Foot


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Fragmentation The Self-Storage sector is a very fragmented area of business, therefore placing the bigger REITS in positions where they can easily be consolidators of smaller businesses in the same sector. The four publicly traded self-storage REIT companies are Sovran Self Storage (NYSE: SSS), Public Storage (NYSE: PSA), Cubesmart (NYSE: CUBE), and Extra Space (NYSE: EXR). In regards to the 2014 Self-Storage Almanac, of the approximate amount of 58,000 facilities in the United States around 11% are managed by the 10 largest operators. With only a small percentage of facilities being owned and operated by REITS, approximately 30,800 facilities are operated and owned by mom and pop owners. Of the large operators, primarily the REITS, they have been able to utilize their owned properties at levels of profitability that was not possible a few years ago due to efficiencies of scale and well as internal revenue management systems. Self-Storage Future Growth Relatively safe investments due to the nature of REITs, there are still prevalent threats. Primarily those threats come from Macroeconomic trends due to REITs having a very cyclical nature, more specifically when the economy does well REITs tend to do well. The primary factors that push future growth are occupancy, rental rates, concessions, and acquisitions. For Sovran Self Storage, occupancy rates are at a very high level, experiencing rates in the lower to mid-90’s range. In 2011 SSS had an 82% average occupancy rate and have recently increased to 90% and are projecting higher rates for next year. Due to these record high occupancy rates we predict more of the future growth to come from rental rates and acquisitions; due to these high occupancy rates it will also be challenging for other players within the self-storage to provide services unless already in the business, therefore there is minimal immediate threat of new supply other than the existing players. Among REITS, self-storage is a niche, but in most cases for REITS performance and future growth is more impacted by macroeconomic events rather than impacted by business itself. Important to note, self-storage REITS are also more resistant to recessions than other asset class areas, but nevertheless downturns in the economy still hurt everyone. Leverage vs Industry Due to the tax laws surrounding REITs, around 90% of taxable income has to be distributed as dividends to shareholders. For Sovran Self Storage and other REITs, this means it can be difficult to maintain retained earnings; therefore to grow Sovran Self Storage must issue both debt and equity. Regarding funding for future acquisitions which has a big role in future growth, Sovran Self Storage matches funding with 60% to 77% being equity, with the remainder being debt.

Sources: Sovran November 2014 Investor Presentation


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Investment Summary

We feel Sovran Self Storage is a well-managed, high quality company with excellent prospects as an industry consolidator in a highly profitable, fragmented niche of the US real estate sector. Sovran is not the largest self-storage company in the US. That honor belongs to Public Storage (PSA). The company also does not rank supreme on key performance metrics like occupancy and REVPAF. That said, Sovran is sufficiently differentiated from Public Storage and other prominent peers due to:

Geographic location – Sovran has avoided the volatile, expensive California market and is located in just 25 states, most of which border the East Coast and Gulf of Mexico.

Property profile – Sovran prefers high quality “Tier 1” properties – typically multi-story structures with excellent signage, HVAC, security, and humidity controls – in Tier 1/Tier 2 markets (ex: Jacksonville).

Further, we believe the extent of fragmentation in the industry is such that Sovran can continue to grow and act as an industry consolidator for several years hence even as large peers do the same. The largest 10 self-storage companies control less than 15% of the industry.

Most self-storage properties are controlled by small, private owner-operators. Sovran and other large peers have a significant advantage over these firms. For one, scale allows them to spread corporate overhead over a much larger portfolio of properties – turning a much larger percentage of NOI into FFO. Sovran is also


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able to invest in better information and customer service systems to drive profitability. Its Customer Care Center handles inbound inquiries for all of its owned and managed properties. It can handle as much as 42,000 calls per month. Over 98% of inbound calls are answered compared to 60% or less at mom-and-pop shops, that according to Sovran. Its revenue management system is also far superior to small firms, which often use little more than reactionary judgment in setting prices. This allows the company’s properties to sport higher occupancy rates and REVPAF than most in the industry. As a result, the company can acquire a property at a fair market rate from a smaller peer relative to current NOI, substantially improve that NOI, and end up actually receiving a bargain. Sovran’s management team is seasoned and understands this. The company’s Chairman/former CEO and current CEO have both been with the company since its founding and both have 30+ years of experience in the self-storage industry.

While we feel Sovran is a great company, we are somewhat skeptical that the stock is an attractive investment at this point. Sovran and its publicly traded peers’ stocks all sit at all-time highs. Interest rates are at a 75-year low and have pulled cap rates below their normalized level as well. Lack of supply over the last few years has also brought self-storage industry occupancy rates to an all-time high, but outsiders have taken notice and new capital is coming into the sector with significant increases in supply expected in 2 years. There is uncertainty when and to what extent interest/cap rates will revert, but we believe they will at some point and that that, more than anything else, makes Sovran a sell.

Financial Analysis

We have conducted an in-depth analysis of the company’s financial statements and created a 3-statement model that includes a complete Income Statement, Statement of Cash Flows, and an abbreviated Balance Sheet. The model can be found in Appendix Section 2. We included only an abbreviated balance sheet reflecting our belief that the company should be analyzed exclusively as a going concern. The company has no debt repayments due until 2016 and we foresee it having no difficulty meeting its interest payments in the meantime. It has investment grade credit ratings and weathered the financial crisis in 2008-09 without missing dividend payments. It also remained profitable. As such we see a negligible risk of bankruptcy over the next few years. The abbreviated balance sheet is further supplemented through our addition of a financing worksheet. As it is Sovern’s stated policy to pursue growth primarily through acquisitions, this worksheet provides a detailed analysis of the additional debt and equity that we are projecting that management will issue each year.


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We are assuming that they will seek to maintain a 70%/30% incremental equity/debt ratio as has been used historically and in accordance with management communications. Our projections have been made through 2018 providing a full 5 years of projected data. This was completed three times using a different set of assumptions that represent a ‘bull’ case, ‘bear’ case, and ‘base’ case. A detailed analysis of our base case is depicted in Appendix Section 2. Section 3 then goes into the assumptions that we used to create the 2 alternative scenarios and we have included the income statement from each of those models as well. A lengthy discussion is given there, but briefly the model varies the interest rate outlook affecting interest expense and the capitalization rate of acquired companies. We also vary the occupancy percentage and rental rate per square foot and the EBITDA margin of the firm. We weight each scenario as equally likely in all applications of the model. In general, we expect interest and capitalization rates to increase, Sovran to continue acquiring properties at a moderate rate, rental revenue to increase, and margins to remain stable or improve.

Interest/Cap Rate Outlook We believe cap rates will increase at some point in the future. It is likely but unclear that this will occur over the next 4 years. In our scenarios we assumed the following changes to both capitalization and interest rates over the next 4 years:

· Bear - 200bp increase · Base - 100bp increase · Bull - no change

Valuation

REITs are typically valued based on FFO, AFFO, and NOI. Traditional valuation metrics like net income are less meaningful due to the inclusion of US GAAP-mandated depreciation & amortization on land that actually appreciates in market value over time. Sovran is no exception, as it owns considerable land underlying many of its self-storage facilities. We valued Sovran in three different ways. These methods rely on our models of the company’s financials through FY2018. The numbers used in our valuation represent an average, equally weighted, of the three scenarios that we detailed in our financial analysis section. The methods used to create our valuation were an analysis of comparable companies, and then an IRR based model though 2016 and through 2018. The model, its assumptions are outlined in detail in the appendix sections 4 and 5.

Source: Multpl (www.multpl.com/interest rate/)


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The first valuation method we used was comparative valuation that assigned a multiple to FFO based on comparable companies to Sovern. On this metric we found that Sovern is relatively undervalued relative to its peers. Strictly applying what we think is a fair multiple to our forecast of Sovern’s 2014 FFO results in a share price of $105.40, an upside of 15.7% to the current price. However, we are skeptical that such a price represents a true representation of the intrinsic value of Sovern. As all self-storage companies have seen material price appreciation over the last few years it is possible that investors have been overly exuberant in the multiples they have been assigning to the industry. Notably, Public Storage trades at just a 4.5% cap rate.

Instead, we gave much more weight to our absolute-basis valuation, where we calculated the IRR to be expected over the next 2 and 4 years. This analysis concluded that an investor would have received an IRR of 4.01% if they held the stock through 2016 and an IRR of 4.14% if they held through 2018. We believe this is far too low. We elected to calculate a starting equity price that would deliver a holding period return of 7.5%, a value that we consider fair in light of current market conditions and other factors detailed in the appendix. This gave us a fair value per share of $85.37 and $80.80 if holding through 2016 and 2018 respectively, or an average of $83.09.

Investment RisksMarket RiskSSS is a publicly traded security and as such any investment in SSS is subject to the broader swings in the market and the market’s overall risk premium. This may change and could led to gains or losses regardless of changes to the underlying business of Sovern Self-Storage. Interest Rate RiskAs a REIT the performance of Sovern Self-Storage is highly correlated with the 10 year US treasury rate. This rate effects nearly all aspects of an investment in SSS. It effects the cost of future debt but also closely affects the capitalization rate that investors are willing to pay to hold any real estate asset and likewise will affect the ability of Sovern Self Storage in acquisition of other storage facilities whose price is tied to the broader interest rate environment. Acquisition RiskThere is a risk that Sovern Self Storage is unable to continue finding adequate companies at a reasonable price as it has been able to in the past. Such a scenario could adversely affect Sovern Self Storage’s ability to maintain its levels of income growth and


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thus poses a risk to investors who are counting on such rates to continue. Industry Competition & New ConstructionHistorically the largest risk to the self-storage industry is from an increase in supply of new stores. While new construction has been subdued over the past few years, new construction could increase at rates materially different from forecast rates of construction and thus have a respective effect on price charged per square foot. Government Legislative ActionThe REIT structure is a specialized tax structure that has been created through an act of the United States legislature. As such, all REITs face the risk that a subsequent act of congress could eliminate or materially alter the structure. This action would cause an unforeseeable in pact on the stock price of SSS.

Conclusion

Recommendation and Price TargetIn thinking about setting our price target, we discounted the results of the comps analysis and focused on the IRR valuation. Although the comps analysis was informative and directed much of our research, it is less meaningful in this case because some of Sovran’s peers are notably better companies and deserve a premium. Furthermore, it is possible that Sovran’s peers are overvalued. For example, Public Storage trades at a 4.5% cap rate. We then turn to the 83.09 fair price output of the IRR valuation. The 8.79% downside it implies does not represent an extreme move over 12 months. We also have more conviction in this number due to:

Sovran stock and its peers sitting at 52-week and multi-year highs.

Our bearish outlook on interest rates Our analysis is grounded in extensive fundamental analysis.

Therefore, we assume this as our 1-year price target. Seeing as it implies non-trivial downside for a quasi-fixed-income security, we recommend that investors sell Sovran shares at this time and price ($91.09, January 11, 2015).


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Disclosures:Ownership and material conflicts of interest:The author(s), or a member of their household, of this report does not hold a financial interest in the securities of this company.The author(s), or a member of their household, of this report does not know of the existence of any conflicts of interest that might bias the content or publication of this report.Receipt of compensation:Compensation of the author(s) of this report is not based on investment banking revenue.Position as an officer or director:The author(s), or a member of their household, does not serve as an officer, director or advisory board member of the subject company.Market making:The author(s) does not act as a market maker in the subject company’s securities.Disclaimer:The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be reliable, but the author(s) does not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report should not be considered to be a recommendation by any individual affiliated with CFA Society of Buffalo, CFA Institute or the CFA Institute Research Challenge with regard to this company’s stock.


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Appendix: Sovern Self Storage

Section 1: Competitive Analysis

1. Porters 5 Forces Framework

1. Rivalry among Existing Competitors: 4

Much of the competition is separated geographically across the United States, and although there are plenty of mom and pop store competitors, they don’t have nearly the revenue management capabilities or the resources the larger REITs have at their disposal. The 10 largest businesses own and manage a very small amount of the total number of facilities in the United States and in many cases due to inexpensive dollar contracts there can be little reason for there to be pricing battles between the Self-Storage businesses. 2. Threat of New Entrants (Barriers to Entry): 2

The storage sector within real estate requires lower initial investment, which is a contributing factor to the fragmentation within the sector. The requirements to perform in this business area can be as simple as purchasing land to store items. 3. Threat of Substitute Products: 4

The threat of substitute products is relatively minimal, due to the closest substitute products falling in the category of storage sheds, pods, and space at home. It is important to note, substitutes such as pods may not be permitted by certain living communities. 4. Bargaining Power of Buyers: 5

Self-Storage customers typically have very high switching costs due to the reason that it can be very costly and time restricting to constantly move their items as prices change. Many of these customers Self-Storage businesses face are also very fragmented and don’t have the power to negotiate as easily, especially when they need to store their goods somewhere. 5. Bargaining Power of Suppliers: 5

Historically, the only other parties that may have had contact with the prospective customer were the intermediaries that put the customers and Self-Storage businesses in contact, such as the yellow pages. These intermediaries are not posing any type of forward integration threats into Self-Storage.


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Section 2: Financial Analysis

1. Model Structure

The model consists of four worksheets – Financing, Income Statement, Abbreviated Balance Sheet, and Statement of Cash Flows, with inputs designed for that order.

The Financing worksheet was necessary to supplement the traditional 3-statement model because Sovran is very active in acquiring new self-storage facilities through the issuance of new debt and equity and we wanted to capture the amount of equity and debt that will be issued and its cost accurately. We forecast a change in rentable square feet and assign a cost per square foot to compute the annual financing needs of the company. We then consistently assume that 70% of this incremental capital is raised via the issuance of new equity with the remaining 30% debt in line with management communication. The company’s enterprise value approximates these weights and the company aims to maintain this capital structure by matching it in new issuances. We then derive an average annual share price from trailing AFFO to get the number of shares issued. We forecast a change in incremental interest rate to calculate incremental interest expense.

2. Financing Worksheet


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3. Income Statement

The Income Statement begins with rent revenue, which is calculated from the change in average rentable square feet, occupancy %, and rental rate per square foot. We believe this is consistent with Sovran’s disclosures and common practice in modeling REITs in general. Other Revenue (mainly management fees) is modeled as a percentage change. All operating expenses are modeled as a percentage of total revenue, other than Depreciation & Amortization, which is a percentage of Net PP&E. Interest Expense is equal to the prior year amount plus incremental interest calculated in the Financing Sheet. Diluted Shares Outstanding is equal to the prior year number plus 0.50% to account for stock-based compensation. We also add the shares issuances for the acquisition of new properties as calculated in the financing sheet. To arrive at AFFO, we assume 40 cents of recurring capital expenditures per rentable square foot, based on information provided in the CFA Challenge investor presentation.


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Income Statement

For the Fiscal Period EndingRestated

12 monthsDec-31-2011

Restated12 months

Dec-31-201212 months






Dec-31-2018Currency USD USD USD USD USD USD USD USDRental Revenue 190.15 217.91 253.38 292.24 330.98 362.24 392.64 418.45

Rentable Sq. Ft. 28.94 31.19 32.36 34.50 36.57 38.58 40.51 41.73 Occupancy % 80.70% 85.50% 88.10% 91.10% 91.10% 91.10% 91.10% 91.10%Rental Rate / Sq. Ft. 10.89 10.86 11.54 12.25 12.68 13.12 13.45 13.79

% Change 15.33% 13.26% 9.44% 8.39% 6.58%Other Revenue 12.57 16.18 20.12 24.75 28.46 31.31 33.50 35.85

% Change 23% 15% 10% 7% 7% Total Revenue 202.72 234.08 273.51 316.99 359.45 393.55 426.14 454.30

Property O&M 52.38 55.16 61.32 67.61 75.48 82.25 89.06 94.95 % Of Revenue 25.8% 23.6% 22.4% 21.3% 21.0% 20.9% 20.9% 20.9%

Real Estate Taxes 19.34 22.08 26.50 32.17 37.38 41.13 44.74 47.70 % Of Revenue 9.5% 9.4% 9.7% 10.2% 10.4% 10.5% 10.5% 10.5%

Selling General & Admin Exp. 25.99 32.31 34.94 40.57 46.01 50.37 54.55 58.15 % Of Revenue 12.8% 13.8% 12.8% 12.8% 12.8% 12.8% 12.8% 12.8%

Other 4.325 4.33 4.46 15.53 7.19 7.87 8.52 9.09 % Of Revenue 2.1% 1.8% 1.6% 4.9% 2.0% 2.0% 2.0% 2.0%

Depreciation & Amort. 35.17 40.54 45.23 52.62 60.03 66.91 73.27 76.81 % Of Net PP&E 2.8% 2.9% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0%

Total Operating Exp. 137.20 154.42 172.44 208.51 226.10 248.54 270.15 286.69

Operating Income 65.52 79.66 101.06 108.48 133.35 145.01 155.99 167.61

EBITDA 100.69 120.20 146.30 161.09 193.38 211.93 229.26 244.41 % Margin 49.7% 51.4% 53.5% 50.8% 53.8% 53.9% 53.8% 53.8%

Interest Expense, Total (38.55) (33.17) (32.00) (35.55) (39.17) (44.98) (48.62) (50.99) Interest and Invest. Income 0.08 0.00 0.04 0.31 0.15 0.10 0.10 0.10 Other 1.05 1.62 2.37 4.37 3.59 3.94 4.26 4.54

% Of Revenue 0.52% 0.69% 0.87% 1.38% 1.00% 1.00% 1.00% 1.00% Earnings from Cont. Ops. 28.10 48.12 71.47 77.62 97.92 104.07 111.74 121.26

Earnings of Discontinued Ops. 3.43 7.52 3.12 3.00 3.00 3.00 3.00 3.00 Extraord. Item & Account. Change - - - - - - - - Net Income to Company 31.53 55.64 74.60 80.62 100.92 107.07 114.74 124.26

Minority Int. in Earnings (0.94) (0.51) (0.47) (0.50) (0.60) (0.70) (0.90) (1.00) Net Income 30.59 55.13 74.13 80.12 100.32 106.37 113.84 123.26

FFO 65.76 95.67 119.36 132.73 160.36 173.28 187.11 200.06

Per Share ItemsWeighted Avg. Basic Shares Out. 27.67 29.36 31.30 Weighted Avg. Diluted Shares Out. 27.73 29.49 31.45 34.12 36.45 39.67 41.78 43.22

EPS 1.10 1.87 2.36 2.35 2.75 2.68 2.72 2.85 FFO/Share 2.37 3.24 3.79 3.89 4.40 4.37 4.48 4.63

Recurring Capex 13.80 14.63 15.43 16.20 16.69 AFFO 118.93 145.73 157.85 170.90 183.37 AFFO/Share 3.49 4.00 3.98 4.09 4.24

NOI 216.70 245.98 269.47 291.43 310.65 NOI/Share 6.35 6.75 6.79 6.97 7.19


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4. Balance Sheet

The Balance Sheet is abbreviated and only includes: Gross PP&E, Accumulated Depreciation, and Net PP&E. We did not need any other Balance Sheet information for our analysis as we analyzed the company exclusively as a going concern and there aren’t any non-core assets of interest. Gross PP&E is equal to the prior year balance plus the (1) Net Acquisition of Real Estate Assets and (2) Improvements line items of the Statement of Cash Flows. Accumulated Depreciation equals the prior year balance plus Depreciation & Amortization and Net PP&E equals Gross PP&E less Accumulated Depreciation.

5. Statement of Cash Flows

The Statement of Cash Flows does not contain many major assumptions. Net Acquisition of Real Estate Assets is pulled from the Financing worksheet. For Improvements, the 2014 number is an extrapolation of the company’s 2014 YTD results and the numbers that follow are based on the prior year number plus the growth rate of the company’s rentable square feet. The debt repayment in 2016 is the only maturity in the next 4 years. Dividends paid are modeled at 92.5% of net income. As a REIT, Sovran is required to pay out at least 90% of its taxable income (different from US GAAP net income) as dividends. Absent the Taxable Income number, we find 92.5% of Net Income to be a good approximation.


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Section 3: Scenario Analysis

1. Model Cases, Assumptions, and OutputsGiven the uncertainty around several factors that will have a major impact on Sovran’s financials, including changes in cap rates and occupancy just to name a few, we thought it best to come up with multiple modeling cases with varying degrees of conservatism.

The table below presents our three cases and the assumptions of each:

Bear Base BullMacro Assumptions:10-Year Treasury Note

Steadily rises ~200 bp over next 4 years off 75-year low and, in turn, cap rates rise.

Rises ~100 bp over next 4 years.

No change over next 4 years.

Competition in Self-Storage Industry

New developments/capital negatively impact self-storage industry.

Competition from new developments negatively impacts self-storage industry, but somewhat less severe and does not become a factor until 2 years out.

Competition decreases slightly in self-storage sector as new capital has trouble with zoning and other aspects of development and major players remain rational.

Model Items:Acquisition Costs

Remain constant as the secular price decline from higher cap rates is completely offset by a flood of new capital.

Decrease 2% per annum over next 2 years with rising cap rates and little new competition followed by -1% in 2017 and ’18 with a continued rise in interest rates and some new competition. Finishes 5.9% lower than FY14.

No change with constant cap rates and absence of incremental competition for properties.

Average Share Price

Declines as cap rate increase results in multiple contraction for most REITs and rising interest rates make fixed income alternatives relatively more appealing.

Decreases less significantly as cap rate increase is smaller than in Bear Case.

Increases with constant multiple.


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Incremental Interest Rate

Rises 200 bp from Current weighted average.

Rises 100 bp from Current weighted average.

No change from Current weighted average.

Occupancy Declines 400bp from historic high >90%.

Remains flat at historic high > 90%.

Steadily increases to 93% in 2018.

Rental Rate/SF

Inflationary pass-through increase slightly offset by increasing competition; 2% increase per annum.

Inflationary pass-through increase and improvement in revenue management system slightly offset by competition; +3.5% in 2015 and 2016, +2.5% in 2017 and 2018.

Little inflation but continued lack of competition and revenue management system yield 4% annual increase.

EBITDA margin

Relatively constant 2015-2018 at 53.8%

Relatively constant 2015-2018 at 53.8%

Improvement in all categories to 58.9% in 2018.


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2. Bear Case Income Statement

Income Statement - Bear



Restated12 months














Other 4.325 4.33 4.46 15.53 7.10 7.60 8.07 8.48 % Of Revenue 2.1% 1.8% 1.6% 4.9% 2.0% 2.0% 2.0% 2.0%




EBITDA 100.69 120.20 146.30 161.09 191.10 204.54 217.06 227.99 % Margin 49.7% 51.4% 53.5% 50.8% 53.8% 53.9% 53.8% 53.8%





FFO 65.76 95.67 119.36 132.73 157.76 164.71 172.89 180.92


EPS 1.10 1.87 2.36 2.35 2.67 2.43 2.32 2.32 FFO/Share 2.37 3.24 3.79 3.89 4.32 4.12 4.07 4.08


NOI 216.70 243.07 260.06 275.87 289.71 NOI/Share 6.35 6.66 6.50 6.49 6.54


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3. Bull Case Income Statement

Income Statement - Bull Scenario



Restated12 months














Other 4.325 4.33 4.46 15.53 7.22 7.98 8.76 9.51 % Of Revenue 2.1% 1.8% 1.6% 4.9% 2.0% 2.0% 2.0% 2.0%




EBITDA 100.69 120.20 146.30 161.09 199.63 225.32 252.68 280.09 % Margin 49.7% 51.4% 53.5% 50.8% 55.3% 56.5% 57.7% 58.9%





FFO 65.76 95.67 119.36 132.73 166.74 187.32 211.61 237.25


EPS 1.10 1.87 2.36 2.35 2.92 3.03 3.32 3.74 FFO/Share 2.37 3.24 3.79 3.89 4.57 4.74 5.11 5.57


NOI 216.70 252.09 282.85 315.28 347.57 NOI/Share 6.35 6.91 7.15 7.61 8.16


January 11, 2015

Section 4: Comparative Valuation

Now that we have fundamental metrics to base our valuation methods off of and have explained the assumptions that we used to calculate these numbers, we will value the stock.We valued the stock on both a relative and absolute basis.

1. Comparables

Our comps analysis indicates moderate upside on Sovran shares of 15.7% to the valuation level of its closest publicly traded peers. We note that all of the publicly traded self-storage firms are trading at a very similar valuation range (23-26x P/FFO). We find this unsurprising as all of the four publicly traded self-storage firms are generally well managed with good prospects as industry consolidators relative to their small, private, owner-operated peers. The one very notable outlier is Public Storage with a cap rate of 4.5%. We believe this is due to Public Storage being perceived by the market as the best-of-breed industry leader. It is by far the largest self-storage company. This puts it in a better position to consolidate the industry and gives the stock a liquidity premium over its peers. Impressively, it has occupancy that is about 300bp higher than Sovran and rental rates/square foot about 13% higher – that despite owning lower tier properties (for the most part single-story boxes in suburban markets). It is also likely perceived as a safer investment because the company does not operate its properties and avoids the associated risks.


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2. 5 Year Price Chart

These four stocks have all delivered outstanding returns over the past 5 years:

We believe they will continue to closely track each other and therefore think it most valuable to determine the industry/secular-level factors that will largely determine the prospective returns of these stocks. The most obvious and probably most influential secular factors are cap rates in US real estate and, more broadly, interest rates, as well as emerging competition in the self-storage industry. This leads us to our second valuation analysis, which is predicated on current and projected future cap rates.


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Section 5: Internal Rate of Return Valuation

1. Capitalization Rate Discussion

What Paul is talking about is we’re willing to pay, say, a 6 cap in Chicago for a mature deal that has the normal upside, let’s say. If we’re doing a CO deal, we would like to see a 9 cap 3.5 years out at maturity. That’s our risk for lease-up, I guess. – Dave Rogers, Sovran CEO, Q3 2014 Conference Call

In the above quote, Sovran’s CEO essentially tells us what the company deems a buy under current conditions in the self-storage industry. Sovran’s portfolio is almost entirely mature properties and so one could infer that management would be interested in repurchasing shares if its stock was valued at a 6% cap rate (16.7x P/NOI). Sovran’s current market price actually values the firm at a 6.94% cap rate, meaning it is moderately cheaper than management’s implicit fair valuation range. This begs the question: Why is Sovran’s management team heavily issuing equity to buy other properties at more expensive valuations when it could be repurchasing its own shares at a lower valuation level. The answer is likely complex, but we feel a few factors are at play:

There is an institutional imperative for Sovran to issue equity and acquire other properties because it gives the firm a market identity as a growth company. Repurchasing shares could cause the market to re-rate shares lower because the stock would be viewed differently.

There is a fundamental difference between Sovran’s existing property portfolio and those properties it is acquiring at 6-caps. We believe this difference is most likely to be in occupancy % and rental rate per square foot. In the firm’s presentation to the CFA competition teams, they mentioned that many of the mature properties they acquire have occupancy rates of 87-88% and suboptimal pricing due to them lacking the support of a sophisticated revenue management system such as Sovran’s. In other words, there is more room for incremental improvement in the properties being acquired than those the firm already owns. Hence, the following quote:

We issued a little more equity in 3Q than we had expected. We were trading at a reasonable level compared to cap rates we were paying. We thought it made sense to take advantage of that. – Andrew Gregoire, Sovran CFO, Q3 2014 Conference Call

Management is admitting that its portfolio is less attractively-valued than other properties in the self-storage market. This makes us comfortable conservatively assuming that the portfolio’s current implicit cap rate is fair.

We then project out a change in cap rates to both 2016 and 2018 that accompanies all of our modeling cases and weight each case equally to see the average IRRs to be expected through 2016 and 2018 respectively.


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2. Expected IRR through 2016

3. Expected IRR through 2018


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4. Discussion of Fair Value IRR

We get a very similar IRR over both durations of just over 4%. The question then becomes: what IRR is sufficient for Sovran’s equity? We think a 4% IRR for most equities is insufficient. Evidence for this claim abounds. Public Storage has many classes of preferred stock in its capital structure that yield more than 4%. The Series Q Cumulative 6.5% Preferred (Ticker: PSA PRQ) currently yields 6.06%. It trades at about a 7% premium to its liquidation preference and may be redeemed on or after April 14, 2016. In the case of rising interest rates which we deem very likely, Public Storage probably would not redeem the preferreds. So with Public Storage’s preferred, you are getting a security higher in what many would argue is a better self-storage company’s capital structure, with a significantly higher yield. Outside of the self-storage industry, most equities should deliver better than 4% long-term returns. In Stocks for the Long Run, Jeremy Siegel argues at length using extensive data that equities globally deliver 6-7% real long-term returns and have done so for almost two centuries. Adding 2.5% for inflation, that’s 8.5-9.5% per year, much higher than Sovran’s 4%. We thus feel the 4% IRR result indicates Sovran is overvalued.

It is imperative that we quantify the degree of overvaluation though. Although equities should deliver 8.5-9.5% nominal annual returns over very long holding periods (30+ years is Siegel’s operational definition), we feel US public equities are currently priced rather richly and that equities will likely deliver less than 8.5-9.5% annual returns over the next 2-4 years. Some would also argue that Sovran’s equity is less risky than the typical equity because of the business quality of the company, the stability (ignore 2008-09 for a second) of real estate as an asset class over common equity, etc. We think this claim is reasonable. We assume a fair expected IRR for Sovran would be 7.5%. We input a prices into both our 2016 and 2018 IRR calculations, holding all other variables constant, to determine the current share prices at which we would expect Sovran stock to deliver 7.5% IRRs over the next 2 and 4 years.


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5. Fair Value through 2016

6. Fair Value through 2016


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7. IRR Valuation Summary

The result is a fair share price of $85.37 and $80.80 for the IRR calculations through 2016 and 2018 respectively. The 2018 IRR is substantially lower due to the longer time horizon spreading the capital gain over more years. We then averaged these two numbers to come up with an average fair share price of $83.09. We note that this implies just under 9% downside from the current share price.