- Adriano Milani
STORE Capital: buy the superior business model
Updated: Sep 10, 2020
STORE Capital (STOR) is an undervalued REIT with great long-term prospects, despite the currently challenging times. It is prudently managed and has been able to navigate the downturn without cutting its dividend. I believe it is well positioned to return to its late 2019 glory once we leave COVID-19 behind us, and that the current market price reflects the risks faced by its tenants, rather that the risks of STORE itself.
A superior business model
The company operates in the triple net lease space, where the tenant pays for all the expenses related to the property (taxes, insurance, and maintenance). STORE stands for Single Tenant Operational Real Estate, and it summarizes the company key feature: it leases to individual tenants, so a single default does not affect the others (as opposed to what would happen in a mall). Occupancy rates in the industry are close to 100%, and STORE is no exception at 99.5%. The company reports this and other useful statistics on its quarterly earnings presentation:
Each store is a profit center, and 98% of locations provide financial reporting at unit level, so the company can monitor how profitable each store is. This is crucial to their business model: a profitable real estate becomes essential for tenants, making rent payment senior to other non-essential financial liabilities. The company does not lease to investment-grade tenants, by choice: non-rated tenants do not have many financing options, as they have no access to the bond market, so they need STORE more than an investment grade firm would. This allows STORE to get better terms on the lease. The negotiating power, coupled with the credit seniority mentioned above, allows the company to stipulate investment-grade contracts from non-investment-grade tenants, for more than 70% of the portfolio. Additionally, STORE’s median tenant has a fixed charge coverage ratio (FCCR) above 2x, which according to CEO Christopher Volk means being able to tolerate an approximate 40% revenue reduction and still meet the rent obligations.
Finally, STORE itself borrows funds in three forms: with asset-backed securities, with unsecured notes and from a credit facility. As of June 2020, its total debt was around 45% of total assets.
Tenants and COVID-19 impact
STORE leases to tenants operating predominantly in the service sector, which accounts for 65% of the portfolio. The remaining 35% is split between retail and manufacturing. Looking at individual industries, we can see that the portfolio is quite diversified:
Therefore, when considering COVID-19 impact, we have to differentiate among sectors and industries. Manufacturing has seen little disruption from COVID-19: rent collection went down less than 10% in April and May, and it is already back to normal levels since June:
Retail suffered more, as one would expect: STORE focuses on retailers capable of surviving in the e-commerce era, which they manage by having an in-store experience component. This, in turn, made them more vulnerable to COVID-19 related shutdowns. In Q2, retail collection rates dropped towards 80%, but recovered in July to around 93%, as stores reopened. However, it is the service sector that has seen the biggest COVID-19 impact, and due to its major weight on the total portfolio, it has also dragged down the overall collection rate. The company disclosed data on the most impacted industries, and they are all in the service sector, with the exception of furniture (which recovered quite nicely in July, in line with the retail sector):
We can see that movie theatres, health clubs, education and family entertainment were all heavily impacted in April and May, with collection rates below 50%. However, they all trended in the right direction in the following months, with the exception of movie theatres, which are far behind in terms of reopening % as well. Restaurants account for 13.6% of STORE portfolio, by far the largest exposure in a single industry. They have been impacted a bit less than other industries, but although they were close to 100% reopening in July, they still had just 80% of collection rate: to me this is a clear indication of the challenges restaurants are facing in adjusting to the COVID-19 world.
How do these data translate in terms of actual loss of revenues? In Q2, STORE reported 168 million revenues, or $ 0.63 per share, versus $ 0.67 of Q1: a 6.4% decrease on a per share basis. Therefore, despite an average collection rate of 73% for the full quarter, the actual loss was much smaller. This is because STORE entered in several rent deferral agreement with its tenants, and recognized a portion of these deferrals as revenues. Management commented on the situation in the following terms:
“Although the rent relief we provided our tenants was primarily in the form of events deferrals, we did not accrue rental income in situations where the collectability of the rental payments wasn't certain. In addition, we recorded $2 million reserve against the deferred rent receivables. Both of these factors reduced total revenues for the quarter. We recognized $38 million of net non-cash rental revenue related to COVID deferrals during the quarter”.
They also commented that some of these rent deferrals go into Q3 and Q4 2020, but are subject to further modification (some tenants already elected to repay earlier than agreed). In general, they expect to receive most of the deferred rent within the year.
Rent collection and dividend safety
One of the main reasons to own a REIT is the dividend, so I will start my valuation looking at that angle. STORE has a history of steady dividend growth, coupled with a very prudent AFFO payout ratio of 70% or less.
This approach allowed the company to protect the dividend and generate internal growth, as they reinvested the remaining 30% of AFFO into the business. COVID-19 put the dividend safety argument to the test, and it seems that the company has passed it: in Q2 they confirmed the $ 0.35 quarterly dividend, despite a decrease of 11.3% in AFFO per share versus Q1 ($ 0.44, versus $ 0.49). As already discussed, Q2 revenues include 38 million of net rent deferrals ($ 0.16 per share), therefore, “cash AFFO” was just $ 0.28 in the quarter, for a “cash payout ratio” of 125%. Management said that, had the Q2 situation persisted for the full year, they would have not been able to sustain the dividend. However, they also disclosed that rent collection rates improved to 86% in both July and August, which makes them believe they will have enough funds to cover the dividend for the full year, and have some room on top of that.
Given the dividend safety, my fist valuation model is a simple two stage discounted dividend model, where I assume STORE will keep its dividend at $ 0.35 per quarter until the end of 2021, to then increase it at a pace of 5.5% per year, forever.
I will use a discount rate of 10%, which is my expected rate of return on the investment. This gives me a value of $ 28.41, slightly higher than current market price.
Dividend yield repricing
Still looking at the dividend, another angle is the yield. Historically, STORE traded between 3.5% and 5.5% dividend yield, and right now it is on the high end of this range, down from the highs touched in March and April, when uncertainty peaked.
In the meantime, the 10-year US Treasury bill decreased from about 2% to 0.6%, so the spread versus STORE dividend yield has increased significantly.
I do not think STORE should offer a 5% dividend yield in such a low interest rate environment, and I believe investors looking for income generation will turn to STORE as soon as it is perceived as safe again. Here is how the stock would reprice at lower yields, with its current $ 1.40 yearly dividend.
STORE historically traded in a 15-19x AFFO multiple range. One can argue that these are not normal times, so such a backward looking comparison is not useful. Think about it as a measure of where it will trade once COVID-19 goes away, say at the end of 2021. I will take the midpoint multiple 17x and consider four AFFO growth scenarios.
As already discussed, AFFO decreased 11% from Q1 to Q2, and LTM it is down 3% compared to 2019. I will assume a full year decrease of 5%, for an expected 2020 AFFO of $ 1.89 per share. In my worst-case scenario, 2021 resembles 2020 and AFFO decrease another 5%. Still, at 17x multiple, the share would trade at $ 30.52, for a present value of $ 26.46, at a 10% discount rate. Even in this scenario, the downside is minimal.
In my best-case scenario, STORE is able to grow AFFO 10% in 2022 already. This is above its 5-year AFFO growth average of 7.3%, and results in a share price of $ 30.63 in present value. While such upside does not look that great, consider that I am applying a 10% discount rate. The actual share price at the end of 2021 would be $ 35.34.
Insiders are buying, Berkshire increased
Other good signs come from insiders and notable investors: in Q2 Berkshire increased its position by 31.11%, and insiders have been buying since March, when the stock hit the low 30’s.
The main risk is obviously a second massive shutdown of the economy due to COVID-19. I believe states are now much more informed and ready to react to a “second wave”, so we are more likely to see local shutdowns in delimited areas than general closure of states. Nevertheless, if stores have to close again, the company will suffer. Should this happen, how fragile would STORE be? Looking at several metrics, I am reassured: as we have seen, the occupancy rate is at 99.5% and has been stable quarter on quarter so far. It might go down due to an increase in defaults, but there is no sign of heavy disruption yet.
The latest reported fixed charge coverage ratio (FCCR) was 2.1x for the median unit and 3.0x for the weighted average unit. However, management commented that these figures reflect Q1 numbers. Q2 numbers were due on August 15 and the company did not disclose them yet. They are going to be lower, sure, but in my opinion there is enough margin of safety, as the starting point is above 2x.
As already mentioned, leverage is around 45% and well below the financial covenant related to its unsecured debt. The company has more than sufficient margin on each covenant:
Furthermore, STORE announced in August that they have already repaid $ 450 million out of the 600 they drew from the credit facility, commenting that they were confident in doing so thanks to the high level of rent collections and the consistency of their portfolio performance. So overall, I think the risk/reward profile here looks quite interesting.
STORE is a buy due to its superior business model, a history of growth, its excellent and transparent management and an attractive price. It might take some time for the stock to climb above $ 35 again, but in my opinion, the long-term prospects of the business more than compensate for the short-term risks linked to COVID-19.
Article written by Adriano Milani
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Disclosure: Integer Investments owns shares of STOR in its portfolio. We acquired shares at an average price of $22.84.