Realty Income Corporation: The Price Problem

| About: Realty Income (O)

Summary

O is a very strong company, but I maintain a neutral rating because prices remain too high.

Looking into the metrics on a per share basis shows that growth for Realty Income Corporation has not kept pace with price growth.

The company’s financial statements and non-GAAP metrics are impeccably high in terms of quality. There are no stupid adjustments.

O recently issued some new debt, but I would like to see the company growing more rapidly since they have low costs on both debt and equity.

Realty Income Corporation (NYSE:O) is one of the strongest triple net lease REITs. I like the sector and admire the company. However, over the summer I sold off my exposure to the sector, which came from shares of National Retail Properties (NYSE:NNN) and STORE Capital (NYSE:STOR). The challenge facing the sector came from valuations, not from any fundamental problem within the companies. Consequently, handling ratings on the company is much more complex. Positive ratings can be easily established if valuations are favorable and the company is strong. If those factors are in place, eventually positive ratings turn out correct in the sense of positive nominal returns. On the other hand, if an investor is concerned the security is overpriced and yet sees a strong company with a great plan, the bearish rating only works if the market eventually changes their outlook and allows shares to trade lower.

This is a major challenge to analysis. I'm confident that even investors who bought at the highs over the summer will end up with positive returns if they are holding for two decades. The dividend yield isn't particularly high, but the dividend is very healthy. The fundamentals of the company are strong so the company should have no problem continuing the small dividend increases. This is why my ratings on the strongest triple net lease REITs tend to vary between buy ratings and neutral ratings. I prefer to limit bearish ratings to companies that have fundamental problems or are very severely overpriced.

The same problems are present for National Retail Properties and STORE Capital.

Looking Into Realty Income Corporation

Assessment of Realty Income Corporation should usually begin with dividends and FFO (funds from operations). However, some REITs create their own formulas for FFO or for AFFO (adjusted funds from operations). In some cases, those formulas produce dollar values that are completely irrelevant to investing. Fortunately, I've never seen poor quality adjustments from Realty Income Corporation. Their financial statements and presentations have been exceptionally high in quality.

Charting It Out

Since FFO, or in some cases AFFO, is a critical piece in evaluating equity REITs, I want to start with a chart that tracks the change in price, FFO per share, and revenue per share.

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The inclusion of revenue per share could draw some eyes. REITs absolutely should not trade on a price to sales ratio, so be careful about interpretation of some of these metrics. The reason I'm including each of them is to demonstrate the trends in share price and the trends in the financial statements.

Prices on the common stock of O have risen dramatically, at least prior to the last few months. The run higher in shares requires us to assess whether the company has changed substantially. Over the last few years revenue per share has been moving higher, but it has really been relatively flat over the last couple of years after a huge climb several years ago. The "Average" growth rate here could be misleading. Despite the weak growth in revenue, the level of FFO per share has been growing as the company was able to translate a larger portion of revenue into FFO.

If Realty Income Corporation were a REIT where I doubted the quality of their accounting adjustments, I would feel compelled to dig deeper into the change. However, I've already spent quite a bit of time reviewing O and each time came up empty. Consequently, I see this as a positive development in the company effectively controlling their costs. However, as you'll see in the next section, there is another factor at work.

Metrics Across the Company

As a strong REIT, Realty Income Corporation may often see their total enterprise value (market capitalization of all equity and debt) exceed the value of their assets. This can be viewed simply as the market putting a premium on wanting high quality management. It is also an incentive for the company to expand through either issuing new debt or new equity. Recently Realty Income Corporation took on new debt. In my opinion, that is a great choice because the expected returns on that debt dramatically outweigh the cost to service it.

The next step in assessing the company is looking at the total revenue, EBITDA, FFO, and interest expense. The reason for running these metrics is assess whether the company is growing in total and what kind of margins they are seeing over time:

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It is important to point out that a company could be shrinking by selling assets and repurchasing shares. That could be an excellent decision if it drove values higher on a per share basis. They could also be issuing shares and growing the company. Depending on the values in place, that could also be a great idea. In the current situation, I believe issuing both debt and equity to fund acquisitions is very intelligent.

It is up to the management to determine which activity will add value for shareholders, and it is up to the investors and analysts to determine if management was right. My view is clearly in favor of expansion.

The growth across all metrics clearly identifies that the company is expanding substantially. However, the similar slope of the top 3 lines also indicates that the margins have performed fairly well. It may look like FFO is not growing as quickly as revenue or EBITDA, but that is an optical illusion. The percentage growth for FFO was outpacing the percentage growth for revenue.

We can also see total interest expense growing, but at a slightly slower rate. That makes sense since new borrowing by Realty Income Corporation will come at lower costs. The company has a great rating on their debt. Treasury yields are low and the spread isn't too large. Consequently, O is able to take on debt at very attractive terms. You may also notice that the total interest expense and FFO combine to be similar to EBITDA. Like I said, Realty Income Corporation's statements don't include absurd adjustments. They recently priced an offering for $600 million in notes due in 2027 at 3% interest.

FFO Reconciliation

The following image from O's Q2 Earnings Release shows the FFO adjustments:

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Yeah, the reconciliation from net income is pretty short. No absurd adjustments.

Conclusion

Realty Income Corporation is a great company, but the price has not declined to the point where I would feel comfortable going back to a positive rating. I'm going to remain at a neutral rating. Because the fundamentals are all strong (excluding ratios involving share price or enterprise value), I would be very interested in the company at the right price. When would I put a big upgrade out there and go to market with a buy order? Probably north of $50 per share, but I haven't nailed down the exact price. We're still far enough away that an exact price isn't necessary.

If you're not sure why O declined so much over the last couple months, the answer is Treasuries. O carries a strong correlation with Treasury prices. When rates are climbing higher, prices on Treasuries are falling and O will usually fall with them. When Treasury prices climb, O tends to climb as well. As it stands, my portfolio is a bit overweight on yield sensitive investments.

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: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis. Tipranks: No rating or reissuing a neutral rating.