By Valuentum Analysts
CubeSmart (CUBE) is one of the best income growth plays out there, in our view. The self-storage real estate investment trust (‘REIT’) is focused on the U.S., an attractive market supported by secular growth tailwinds. Surging housing prices are encouraging a larger number of households to turn to self-storage options as a way to economically maximize their living space, creating an immense growth opportunity for CubeSmart.
As of this writing, shares of CUBE yield a nice ~3.4% on a forward-looking basis after CubeSmart announced it had increased its quarterly payout by over 26% sequentially in November 2021. We expect CubeSmart will continue to push through sizable payout increases over the coming years.
The REIT owned an economic interest in 540+ properties across ~24 states and Washington DC as of the end of September 2021. In December 2021, CubeSmart closed its acquisition of the owner of the Storage West self-storage platform, LAACO LTD. This acquisition added self-storage facilities to CubeSmart’s operations in Southern California (San Diego and Inland Empire), Arizona (Phoenix), Nevada (Las Vegas), and Texas (Houston). CubeSmart intends to continue growing its self-storage property footprint, with an eye towards metropolitan markets. It was founded in 2004 and is headquartered in Malvern, Pennsylvania.
CubeSmart’s third-party management platform had 700+ self-storage properties participating in the program at the end of the third quarter of 2021. The REIT has done a great job building up this business and intends to keep growing this operation going forward. The self-storage market in the US and elsewhere remains highly fragmented, and its third-party management platform service can be used at times to identify future acquisitions.
We are impressed with CubeSmart’s very robust free cash flow generating abilities, defining free cash flows as net operating cash flows less capital expenditures. Please note that many entities in the REIT industry tend to generate modest free cash flows, given their hefty capital expenditure requirements, and fail to cover distributions with traditional free cash flow. CubeSmart is somewhat different, however, as the first nine months of 2021 have shown.
The ability for CubeSmart and self-storage firms to generate free cash flows that are very close to covering their cash distributions is a big reason why we like this slice (self-storage segment) of the REIT industry when searching for income growth opportunities. For one, creditors should be much more open to lending to a company that can cover distributions internally with free cash flow than one that needs external capital to do so.
Let’s examine the image below to assess CubeSmart’s capital-market dependency with respect to its free cash flow coverage of the payout. Then, we’ll cover why the first nine months so far in 2021 had been so robust with respect to free cash flow coverage of the payout that a huge dividend increase could only have been expected.
Image Shown: CubeSmart’s annual cash flow statement from its latest 10-K filing.
The key components in the image above are highlighted to determine whether a firm may be capital-market dependent when it comes to covering its distributions. In the case of CubeSmart, ‘additions to property plant and equipment’ and ‘development costs’ are subtracted from ‘net cash provided by operating activities,’ and this difference called traditional free cash flow is compared to the sum of distributions paid to the company’s shareholders to assess capital-market dependence risk of the payout. In 2020, for example, CubeSmart generated $246 million in free cash flow and paid out ~$259 million in dividends.
Though very, very close, it paid more out in dividends than it generated in traditional free cash flow (it also paid out more in dividends than internally-generated free cash flow in the prior years, too). This means that CubeSmart is a modestly capital-market dependent entity when it came to dividend coverage the past few years. CubeSmart also has a large net debt load (which stood just over $2.2 billion at the end of September 2021, inclusive of short-term debt and excluding restricted cash). Retaining access to debt and equity markets at attractive rates to refinance maturing debt, fund acquisitions and other growth endeavors, and continue meeting its dividend obligations are a key part of CubeSmart’s business model.
Recent financing activities, including a secondary equity offering and senior note issuances conducted in November 2021, indicate that remains the case which we really appreciate. No matter how much we may like CubeSmart’s fundamentals, however, its share price will be sensitive to changes in interest rates. The current environment reveals a 10-year Treasury rate that is materially lower than that offered by CubeSmart’s yield. However, the 10-year Treasury rate is worth watching closely, as it has popped quite a bit so far in 2022.
Cash Flow Analysis
Image Shown: CubeSmart has a high-quality cash flow profile. Image Source: Valuentum
From 2018-2020, CubeSmart generated just over $0.2 billion in annual free cash flow on average, and its run-rate dividend payout obligations stood at ~$0.25 billion in 2020. This highlights CubeSmart’s rock-solid free cash flow generating abilities, but also that traditional free cash flow doesn’t quite cover dividend obligations.
For a REIT, however, CubeSmart is in great shape, as most REITs don’t come anywhere close to covering cash distributions with traditional free cash flow. Investors should nonetheless expect CubeSmart to continue to need to tap capital markets for funds to cover its dividend obligations and growth ambitions.
The first nine months of 2021, however, were simply incredible with respect to traditional free cash flow generation! During this time, CubeSmart generated $342.9 million in cash flow from operations and a total of $93.4 million in capital spending, good for free cash flow generation of $249.6 million, in excess of cash distributions paid of $210.6 million (see image below).
Things are going so good at CubeSmart that it covered cash distributions paid with traditional free cash flow through the first nine months of 2021 by a large margin. We think this is largely why we saw such a huge dividend increase at the company. For REITs that cover distributions with internally-generated free cash flow, the dividend growth potential is even greater than those without, and that describes CubeSmart, in particular!
Image Shown: CubeSmart’s cash flow statement for the first nine months of 2021. 10-Q filing.
Recent Performance and Guidance Overview
CubeSmart’s same store occupancy rate averaged 95.6% in the third quarter of 2021. Strong occupancy performance combined with sizable pricing increases enabled CubeSmart to grow its same store net operating income (‘NOI’) by 21% year-over-year in the third quarter of 2021, with revenue growth of 16% offsetting a 4% increase in its property operating expenses. We appreciate CubeSmart’s operating leverage, meaning that revenue growth can translate into meaningful margin expansion.
The REIT’s strong performance in the third quarter gave management the confidence to raise CubeSmart’s full-year guidance for 2021 once again. Please note that CubeSmart also raised its 2021 guidance in conjunction with its first and second quarter earnings updates.
Now CubeSmart aims to generate 16.5%-17.5% same store NOI growth in 2021 (up from 13%-14% previously) on a year-over-year basis as its same store revenue growth is expected to come in stronger the previously forecasted while expected growth in its property operating expenses is expected to come in marginally softer than previously forecasted (at the updated midpoint of guidance for both metrics).
Additionally, CubeSmart also expects to post $2.09-$2.10 in funds from operations (‘FFO’) per share in 2021, up from guidance calling for $1.99-$2.03 in FFO per share. FFO is a non-GAAP industry-specific metric used to gauge the cash flow performance of a REIT, though that metric has its flaws (free cash flows are the best way to measure a firm’s ability to meet its future payout obligations).
Please note that CubeSmart’s full-year forecasts for 2021 as of the third quarter are up sharply from the guidance put forward when the REIT published its fourth quarter of 2020 earnings report. The outlook for the self-storage industry in the US has improved materially over the past year. Looking ahead, there is ample room for firms like CubeSmart to continue expanding at a robust pace as domestic demand for self-storage services is growing rapidly while the industry remains highly fragmented.
We think CubeSmart is worth $56 per share under our “base” case scenario with a fair value range of $45-$67 per share (the lower rung represents our “bear” case scenario and the upper rung represents our “bull” case scenario). Here, we would like to stress that we derived CubeSmart’s intrinsic value by forecasting its free cash flows into perpetuity, discounted those future forecasted free cash flows at the appropriate rate which is the REIT’s estimated weighted average cost of capital [‘WACC’], and then took its balance sheet considerations into account. The near-term operating forecasts used in our enterprise cash flow models, including revenue and earnings forecasts, do not differ much from consensus estimates or management guidance.
Our enterprise cash flow model reflects a compound annual revenue growth rate of 10% during the next five years (a feat that we forecast can be accomplished through a combination of expected asset base growth, solid occupancy rate performance, and future pricing increases) a pace that is higher than the firm’s 3-year historical compound annual growth rate of 6.7%. Furthermore, our enterprise cash flow models reflect a 5-year projected average operating margin of 41.3%, which is above CubeSmart’s trailing 3-year average. Beyond Year 5, we assume free cash flow will grow at an annual rate of 4.3% for the next 15 years and 3% in perpetuity. For CubeSmart, we use a 7.3% weighted average cost of capital to discount future free cash flows.
Image Shown: An overview of the key valuation assumptions we used in the base case scenario covering CubeSmart. Image Source: Valuentum
Image Shown: An overview of how we calculated CubeSmart’s estimated WACC. Image Source: Valuentum
Image Shown: A visual breakdown of CubeSmart’s intrinsic value by period within its future business cycles. Image Source: Valuentum
Our discounted cash flow process values each stock on the basis of the present value of all future free cash flows. Although we estimate the company’s fair value at about $56 per share, every company has a range of probable fair values that’s created by the uncertainty of key valuation drivers such as future revenue or earnings, for example. After all, if the future were known with certainty, we wouldn’t see much volatility in the markets as stocks would trade precisely at their known fair values.
In the upcoming graphic down below, we show this probable range of fair values for CubeSmart. We think the firm is attractive below $45 per share (the green line), but quite expensive above $67 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion. At $51 per share at the time of this writing, CubeSmart’s shares offer a positive risk/reward situation, from our perspective.
Image Shown: The top end of our fair value estimate range sits at $67 per share of CubeSmart and represents our bull case scenario for CubeSmart. Image Source: Valuentum
In our view, CubeSmart will continue to grow its payout at a robust pace going forward, supported by its improving near-term outlook, promising long-term growth runway, stellar free cash flow generating abilities, ample pricing power, and apparent ability to tap capital markets for funds at attractive rates. Growth at its self-storage asset base via acquisitions and organic growth endeavors combined with expected pricing increases, made possible through the powerful secular tailwinds supporting the industry, should drive CubeSmart’s free cash flows higher over the long haul. CubeSmart is one of the best run self-storage REITs out there and represents a great income growth idea for investors.