Regency's Dividend Cushion Leaves Us Skeptical

| About: Regency Centers (REG)

Summary

Regency's business model is flush with opportunities to improve NOI growth potential from rent steps to rent growth.

Though REG delivers an average of $200 million developments at attractive returns each year, we still prefer Realty Income. Investors should keep an eye on Regency's balance sheet.

Though no brick-and-mortar retailer is immune to the risks of e-commerce proliferation, we would consider ~70% of the REIT's portfolio as relatively Internet resistant.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

Click to enlarge

By The Valuentum Team

Regency's Investment Considerations

Investment Highlights

• Regency (NYSE:REG) is a national owner, operator and developer of dominant grocery-anchored shopping centers. Its top clients include Publix (OTC:PUSH), Safeway (NYSE:SWY), Kroger (NYSE:KR), Albertsons (NYSE:ABS) and Ahold (AHONY). Southern California is its largest market at ~20% of NOI. The REIT was founded in 1963 and went public in 1993.

• Regency's portfolio of grocery-anchored shopping centers sustains 3%+ annual NOI growth. The REIT delivers an average of $200 million developments at attractive returns each year. It is still not our favorite REIT however - we prefer Realty Income (NYSE:O).

• Though no brick-and-mortar retailer is immune to the risks of e-commerce proliferation, we would consider ~70% of the REIT's portfolio as relatively Internet resistant. These tenants would include grocer/specialty, service, restaurant, medical, and health club segments. We would only consider less than 5% of its portfolio truly at risk of obsolescence.

• Regency's business model is flush with opportunities to improve NOI growth potential from rent steps to rent growth. Other opportunities include savings on the operating expense line and driving ancillary income increases. Management is working to "fortify" its future NOI expansion.

• Regency's balance sheet is worth paying close attention to. Management is targeting net debt to core EBITDA of less than 5.5 times and fixed charge coverage of greater than 2.75 times. We'd like to see better targets.

• It is important to note that Regency has been forced to cut its dividend in the past. We remain wary of the firm's dividend coverage in addition to its questionable leverage targets. We aren't expecting material growth in its payout in the near term.

Business Quality

Funds From Operations Analysis

Regency's FFO expansion has trailed both that of its peer group and its industry group during the past three years. We expect the firm's FFO expansion to outpace its peer group and industry group during the next five years. Realty Income sports the highest expected FFO growth rate among peers.

Valuation Analysis

This is the most important portion of our analysis. Below, we outline our valuation assumptions and derive a fair value estimate for shares.

Our discounted cash flow model indicates that Regency's shares are worth between $49 and $81 each. Shares are currently trading at ~$75 per share in the upper half of our fair value range. This indicates that we feel there is more downside risk than upside potential associated with shares at this time.

The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $65 per share represents a price-to-earnings (P/E) ratio of about 23 times last year's earnings and an implied EV/EBITDA multiple of about 24.8 times last year's EBITDA.

Our model reflects a compound annual revenue growth rate of 6.8% during the next five years, a pace that is higher than the firm's three-year historical compound annual growth rate of 4.6%. Our model reflects a five-year projected average operating margin of 38.8%, which is above Regency's trailing three-year average.

Beyond year five, we assume free cash flow will grow at an annual rate of 4.3% for the next 15 years and 3% in perpetuity. For Regency, we use a 7.2% weighted average cost of capital to discount future free cash flows.

Click to enlarge

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $65 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

In the graph above, we show this probable range of fair values for Regency. We think the firm is attractive below $49 per share (the green line), but quite expensive above $81 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.

Future Path of Fair Value

We estimate Regency's fair value at this point in time to be about $65 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Regency's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $75 per share in Year 3 represents our existing fair value per share of $65 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Wrapping Things Up

Regency's business model is flush with opportunities to improve the NOI growth potential from rent steps to rent growth. Other opportunities include savings on the operating expense line and driving ancillary income increases. Management is working to "fortify" its future NOI expansion, and we are fond of its Internet-resistant portfolio. However, Regency's balance sheet is worth paying close attention to. Management is targeting net debt to core EBITDA of less than 5.5 times and fixed charge coverage of greater than 2.75 times. We'd like to see better targets. We are skeptical of the safety of Regency's dividend as evidenced by its Dividend Cushion ratio of 0.5, and the REIT has been forced to cut its dividend in the past. Our favorite REIT remains Realty Income. Regency currently registers a 6 on the Valuentum Buying Index.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: O is included in the Dividend Growth Newsletter portfolio.