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When looking for an acquisition target, sometimes it pays to pick on someone not your own size.
Roy Harris, CFO Magazine
November 1, 2006
With 148 Properties, Extra Space Storage Inc. was a small player in the self-storage business. But it had big dreams. In July 2005, it plunked down $2.3 billion cash for Storage USA, a company with 458 properties in 34 states. In a stroke, Extra Space became the second-largest provider of self-storage, behind Public Storage Co.
Last June, McClatchy Co., publisher of 12 midsize dailies, paid $6.5 billion in cash and stock for Knight-Ridder Inc., a rival three times its size. McClatchy, too, suddenly found itself the number-two player in its industry, and now seems on track to reduce debt and navigate through the newspaper industry's tough times (see "Front-page News" at the end of this article).
The fastest way for a small company to grow big is to acquire a big company, as Extra Space Storage and McClatchy did. But it's not easy for a minnow to swallow a whale. AOL made headlines when it merged with Time Warner in 2001, five years after WorldCom came out of nowhere to buy MCI. Neither result was pretty. "Deals like this can be catastrophic if they don't work," says Mark Sirower, leader of PricewaterhouseCoopers's M&A strategy practice. "They must be very carefully planned, especially if there is stock involved," since stock deals can quickly lose value if shareholders sense that something is amiss.
That said, Sirower applauds the care taken in the financial and operational underpinnings of the ExtraSpace Storage and McClatchy acquisitions. "Compared with some of those earlier deals," he says, "we've learned a few lessons."
Taught By His Own Class
When Kent Christensen joined then-private Extra Space Storage as CFO in 1998, the Salt Lake City–based real estate investment trust was barely noticed in the fragmented self-storage business. It owned just 12 properties and managed 15 others. CEO Kenneth Woolley, however, had begun plotting out growth strategies based on an epiphany he'd had while teaching a business-strategy course at Brigham Young University.
"Ken realized that he didn't have a strategy for himself, personally," says Christensen. Woolley had worked in self-storage for 20 years, including as an acquisition broker for Public Storage, and thought the industry ripe for a fast-growing company. A $100 million joint venture with Prudential Real Estate Investors (PREI) helped Extra Space increase its portfolio fivefold over 7 years, and prepared it for its big leap last year.
The company also benefited from a relationship with GE's commercial finance unit, which had provided financing for previous Extra Space deals. GE itself had entered the self-storage field years earlier, eventually acquiring Storage USA, but not without headaches.
"GE managed self-storage like it manages all its other businesses," says Christensen, and it stumbled in the early years with problems related to the peculiarities of the self-storage business, like the intensely local nature of its operations. GE's image-consciousness also posed a curious burden. "We've had meth[amphetamine] labs discovered on some of our properties," the Extra Space CFO says. While a minor problem for his company, "for GE, having that kind of news on the front page would be really bad publicity."
When GE decided to sell Storage USA, Extra Space was considered a potential buyer despite its small size, mainly because of Woolley's relationship with Prudential. Extra Space wasn't daunted by the $2.3 billion price tag. Meeting with its investment bankers, says Christensen, "we figured we could raise between $500 million and $600 million, and we could leverage for another $400 million." That left a $1 billion gap. He and Woolley made a presentation to PREI asset managers on a Wednesday in November 2003, "and on Friday they said they wanted to do the deal, and they'd come up with $1.8 billion." Extra Space, which went public in 2004, got a $500 million bridge loan for the rest.
At the time, the Prudential deal was the largest ever in self-storage, although Public Storage's purchase of number-three Sureguard has since surpassed it.
The View from PRU
While Prudential did give a quick positive response, recalls PREI capital-markets principal Jim Walker, approval "was always contingent on our doing due diligence on Extra Space." That involved delving into major uncertainties. Even though PREI had a long relationship with Woolley and Christensen, "acquiring a company that was three times [Extra Space's] size had to be a concern for anybody investing alongside them," he says. "And we were putting in the lion's share of the capital."
PREI examined "how we thought the metamorphosis would go in growing to more than 600 properties," he says. It scrutinized the compatibility of the existing company systems with Storage USA's. "Extra Storage had a structure we felt was easily expandable, using a hierarchy of district managers, regional managers, and property managers," says Walker.
Just as important was its ability to meet the exacting reporting requirements of a private-equity venture partner, which "can be very demanding on the resources of an organization when it is trying to focus on operations," says Walker. "These guys were accustomed to financing with money from smaller lenders, where the standards tend to be much lower." PREI helped Extra Space adjust some elements of its reporting to fit the needs of the venture partner.
Under the deal's terms, Extra Space acquired 61 wholly-owned properties and an equity interest in 54 others through existing joint ventures. Five joint-venture subsidiaries of Extra Space and Prudential were set up to acquire 259 properties. Extra Space's funds from operations, the critical performance metric, have risen sharply, and its share price is also up.
To customers and employees, the 600-plus outlets "are managed as though they're all owned by Extra Space," says Christensen. "That gives us a ton of advantages." The cost-per-property of Yellow Page and Internet advertising, vital sales tools in storage, plunges when allocated over multiple outlets, for example.
Critical, too, was retaining the manager who ran the Storage USA operations, along with his key employees. "If we'd acquired these guys and all our site managers took off and quit," says Christensen, "that would have been a disaster."
Roy Harris is a senior editor at CFO.
When McClatchy Co. emerged as the surprise buyer of Knight-Ridder Inc., McClatchy CEO Gary Pruitt described it as a deal coming "perhaps once in a company's lifetime." That was also true of the challenge of paying for the much-larger newspaper publisher.
Financially conservative McClatchy — which had just paid down debt from buying The Minneapolis Star Tribune in 1998 — "looks at everything and moves on almost nothing," says treasurer Elaine Lintecum. The $6.5 billion Knight-Ridder purchase could be justified only if enough acquired papers precisely fit McClatchy's growth criteria, and if those not fitting could fetch at least $2 billion in a sell-off. (Wall Street has been tough lately on slow-growth newspaper chains.) That turned out to be the case.
Sacramento-based McClatchy borrowed $3.08 billion with revolving credit and a five-year bank term loan. Its sale of 12 of Knight-Ridder's 32 papers let McClatchy forgo drawing down on a new $550 million bridge loan. "We looked very objectively at what made sense and what didn't," says Lintecum. The papers sold for 11 times cash flow, compared with the 9 times cash flow paid for all of Knight-Ridder. — R.H.