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Palladium31
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I prefer to research before buying and to monitor while holding. I have a background in tax/finance/accounting with a career focus in the real estate industry. My username has a personal meaning and has nothing to do with the metal.
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  • DLR Charts A New Path

    DLR presented Q1 2014 results yesterday (seekingalpha.com/article/2197183-digital...) and the burning question on everyone's mind has been what is the company doing about their CEO situation. In my humble opinion - Michael Bilerman hit the nail on the head...

    With that aside, after reading the earnings call transcript my thoughts are that the company clearly overbuilt their spec inventory (i.e. building a property before having a tenant(s) lined up) in prior years and the decline in share price in 2013 was a reflection of that. For example, they've had to issue capital in Q1 to repay their credit facility at a blended 5.9% rate (and the company points out this was a more favorable financing environment than expected). At the same time, they are dropping fully leased-up properties into JV's at 7.1-caps. Just imagine what could have happened to spreads had interest rates been unfavorable this quarter and their pref was issued at their prior guidance of 8-8.5 instead of 7.375 (on an upsized offering )...

    Together with the shifts in the data center landscape I had previously written about (e.g. large tenants building their own data centers, increased competition, etc...), this financing experience just goes to show how risky the Company's spec development plan has been - and probably explains why the former CEO had to take a hike, while the Firm charts a new path.

    Although Q1 core FFO was 1.28, as I suspected, when the new financings and dispositions are taken into account (plus some amount of new G&A), the company projects a core FFO run rate of 1.18/quarter. Thus, 1.28+1.18+1.18+1.18 = 4.82 is how they get to their full year core FFO guidance. Had they initiated the financings and dispositions at an earlier point in the quarter, we may be closer to 4.72/share... which is in-line with 2013 and (and in fact 1.18 was 2013 Q1 core FFO).

    A New Path

    On the other hand, the good news is that the company also appears to have two new strategic shifts that may bear long-term fruit beyond 2014:

    1) transition into a build-to-suit model rather than a standardized spec development model; and

    2) recycle under-performing capital into their higher demand markets and utilize JV platforms to share the risk of new development where possible.

    I really like the shift to build-to-suit as it better aligns the use of capital to the proximate need - although, it will be interesting to see how the company manages their development & construction group going forward. For example, the company expects built-to-suit projects to only take 12-16 weeks to deliver - which fits nicely with the 6-month window it typically takes for a tenant to commence their rent term with DLR after initial lease signing.

    I also like the idea of recycling capital and sharing the risk on new developments through JVs - as it can help mitigate the need to raise additional debt or equity capital. Let's just hope the company can effectively manage the complexities of the 1031 like-kind-exchange rules so they don't end up triggering built-in-gains that are needlessly distributed to shareholders instead of recycled as intended.

    Bottom Line

    Since the company really got lucky with the macro situation this quarter by securing long term financing at unexpectedly favorable terms - the spec development overhang becomes largely a wash in my view with several quarters of flattish results before that inventory is fully absorbed. That said, I really like the disciplined strategy Bill presented for capital deployment going forward and therefore I can justify accumulating a common position with my existing preferred position at this time.

    --------------------

    As always, I take no responsibility for your investment decisions and you must perform your own due diligence. This data and any analysis are for informational purposes only and are intended to promote financial literacy.

    Best of luck to everyone,

    Palladium31

    Disclosure: I am long DLR.

    Additional disclosure: I am also long DLR-Pref E shares. I have no other affiliation with the company and I wrote this post myself. Please conduct your own due diligence before making any investment decision.

    May 07 12:25 PM | Link | 8 Comments
  • Should Dividends Wag The Dog?

    (click to enlarge)

    It is often said that one should not let the tail wag the dog, so should dividends wag the company?

    Say a firm sells a product for $100, has $30 of inventory cost, $20 of operating expenses, pays $20 of tax (40% rate) and the business requires on-going capital expenditures of $10/year. This means that the company's cash flow yield from each sale is $100-30-20-20-10 = $20, or 20%. The company also pays $15 of dividends to shareholders (and retains a $5 contingency reserve).

    With a cursory glance, the $15 of dividends generated from every $100 sale may appear rather "juicy".

    But let's think about this one step further: where did that $15 of dividends come from and is there a hidden cost of such high "excess" cash flow?

    From a theoretical standpoint, the company could afford to cut their prices by 15% (or raise costs by the same amount) and still have a positive cash flow yield (because their tax expense would be lower at 14 instead of 20; thus, 85-30-20-14-10 = 11), while also being able to pay dividends of $6 (and retain a $5 contingency reserve).

    So would a 15% price cut (or sales discount) be worth a potential 60% "cut" in the dividend ((15-6)/15 = 60%)?

    One reason this might be worthwhile is if competition is eating into market share. Lower prices, should theoretically generate more demand, right? Stated another way, if sales are stagnant, could the company's dividend be too generous at present?

    Continuing from the example, if every 15% discounted sale at $85 adds $6 to the potential dividend pool, then if the company can generate 2.5 additional sales from a 15% price cut, it would still have $15 ($6*2.5) of dividends to distribute, and the temporary dividend "cut" may not even materialize (and note there would likely be "leverage" on fixed operating expenses, further adding to the bottom line and reducing the number of additional sales necessary to break-even).

    It should go without saying that revenue growth, cash flow growth and EPS growth all tend to lead to higher share price valuations as well, so perhaps this a good strategy.

    There are plenty of iterations and break-even scenarios that we could come up with. But there is a larger point I'm trying to convey here: A low market share (or low revenue growth) may be the price for a high dividend.

    ---------------

    Here is a tool you can use to help screen if a company's dividends are coming at the price of low revenue growth (or market share): consider dividends paid + share buybacks as a percentage of gross profit (I'll call this the payout sales ratio = "PSR").

    If the PSR is much higher than peers, this may be a red flag indicating poor management efficiency and effectiveness. It could also signal that the board of directors are either not doing their job, or just want to milk the company for cash at the expense of the market share and stock valuation. It may also signify management's strategy to borrow long at low rates and buyback stock to lower their cost of capital - so just use the PSR as an initial screen and take a look a the 10K.

    A PSR that is much lower than peers could signal high operating costs or one-time expenses, or it could signal that management is building up cash for an acquisition or debt pay-off. Needless to say, it warrants further analysis if the PSR is way out of line from peers.

    Moreover, a high PSR doesn't necessarily mean the company is a bad investment as a high PSR may be an opportunity for significant share price appreciation if management or the board were to implement a low price/discount optimization strategy similar to what I described above. Alternatively, a low or average PSR doesn't necessarily mean the company is an alpha generating investment (although it is probably a safe investment) if the firm is already optimized for performance... and the market has fully valued the shares.

    -----------------

    Here are a couple of examples from 2013 financials taken from Yahoo Finance. First, some arguably healthy and well known dividend payers (all amounts are approximate):

    PG - Gross Profit = $41.7B, Dividends + buybacks = $9B, PSR = 21.6%

    CL - Gross Profit = $10.2B, Dividends + buybacks = $2.6B, PSR = 25%

    WMT - Gross Profit = $118B, Dividends + buybacks = $13.5B, PSR = 11.5%

    INTC - Gross Profit = $31.5B, Dividends + buybacks = $5.3B, PSR = 16.9%

    Next, here are four less well known names:

    PETS - Gross Profit = $77.1M, Dividends + buybacks = $35.7M, DSR = 46.3%

    CATO - Gross Profit = $348M, Dividends + buybacks = $11.8M, DSR = 3.4%

    CTL - Gross Profit = $10.6B, Dividends + buybacks = $2.8B, DSR = 26%

    TAXI - Gross Profit = $49.8M, Dividends + buybacks = $19.5M, DSR = 39%

    And, in the example I gave above, the PSR would be 21% (15 /(100 -30)) before the discount strategy, and would be 11% (6/ (85 -30)) after the discount strategy.

    -----------------

    Please note that these results are illustrative only and should serve as a spring board for further due diligence on your part. Also, this methodology doesn't necessarily work for every company or entity type (e.g. REITs, MLPs, etc.), and should be expected to vary considerably from industry to industry.

    As always, I take no responsibility for your investment decisions and you must perform your own due diligence. This data and any analysis are for informational purposes only and are intended to promote financial literacy.

    Best of luck to everyone,

    Palladium31

    Disclosure: I am long WMT.

    Additional disclosure: I am effectively long PETS via cash secured puts with a strike price below the current market price. I wrote this post myself and am not receiving any compensation from any of the companies mentioned in this article.

    Apr 11 1:34 AM | Link | Comment!
  • A Riff On Rates And Realty

    In a recent well-written article by Tim McAleenan Jr. seekingalpha.com/article/1865481-should-you-buy-realty-income-at-current-prices, Tim wrote: "When you look at Realty Income's December 31st dividend yield every year since 1994, we see a dividend yield between 4.5% and 11.3%, with most of those figures hovering around the 6%, 7%, and 8% range, once you subtract the extraordinarily low interest rates that have propped up Realty Income's valuation in recent years. Just by taking a cursory look of the company's historical dividend valuation, we can see that the current 5.70% is on the lower end of what can reasonably be called the fair value dividend range."

    For today's blog I wanted to share some thoughts I have on using the dividend yield to determine the value of the stock.

    The following chart reflects the same Current dividend yield of Realty Income (NYSE:O) cited by Tim, and then I've added two columns to reflect the 10-year nominal Treasury yield in each of these periods and the implied "Risk Premium" of O (i.e. the difference between the risk-free 10-year treasury yield and the current dividend yield of O). 10-year treasury data comes from bonds.about.com/gi/o.htm .

    What this tells us is that O trades at an average 2.74% "risk premium" to the 10-year Treasury yield. If we add the 2.74% historical "risk premium" to the 11/26/13 10-year treasury yield of 2.71%, O should theoretically be yielding 5.4%, or $40/share based on 2.182 in forward annualized dividends. In other words, today's price ~$38 is trading below Realty Income's price implied by the historical Risk Premium.

    However, there is another very important point to consider about this data: Both O's current dividend yield and the 10-year treasury are trading about 200 basis points below their historical average. Let us consider for a moment what would happen to O if the 10-year treasury yield were to suddenly spike up 200 basis points to it's historical 4.81% average (during the 1994-2013 time period)? If the risk premium relationship were maintained, investors would require O to yield about 7.55%. Since the dividend yield could be computed by dividing forward 12-month dividends by the current price, if O's current $2.182 of annualized dividends/share remain constant, O's price would need to fall to $28.92 to maintain the risk premium parity. On the other hand, if a $38.33 price per share wanted to stay constant, dividends would need to suddenly rise to $2.892 annualized dividends/share, or rise by $0.71/share. At 206M shares (after the 9.775M issuance in October - see my first blog post for background), $0.71/share represents an additional $146M in distributable cash. At a 1.5% spread (difference between O's borrowing cost and return on new assets), $146M in additional distributable cash represents around $9.75Bn in new asset acquisitions.

    I believe it would be highly improbable that O could suddenly acquire $9.75Bn in new assets overnight given their underwriting/due diligence process, so the most likely scenario in a sudden 10-year yield spike would be a collapse in O's share price to around $28-29/share to maintain the historic risk-premium. That would most certainly be a price with a significant margin of safety, but is definitely not what I'd call a "fair" price as it should only occur in the worst possible scenario (i.e. a reversion to the mean in 10-year treasury rates in a very short time-frame).

    Let's stop here for a second and consider what would happen to the economy in a broader sense if yields on the 10-year spiked 200 basis points to their historical average in a short period of time. I provide the following discussion with the caveat that I am not a macro-economic expert by any means, so please bear with me.

    The following is a chart I've compiled from the same data source bonds.about.com/gi/o.htm. It reflects the 30-year conventional home loan rate compared to the 10-year treasury yield (the 10-year is used instead of the 30-year for comparison purposes with the prior O data), with the difference being the "risk premium" for 30-year conventional mortgages above the "risk-free" 10-year treasury.

    This data shows the historic risk premium for a 30-year mortgage has been on average 1.8% (180 basis points) above the average 10-year treasury yield (based on the 1994-2013 period). If we consider what would happen to the 30-year mortgage rate if the 10-year treasury yield reverted to the mean in a very short timeframe, we should expect mortgage rates to spike up 240 basis points to around 6.6%, or approximately 150% above the current 4.22% 30-year conventional mortgage rate.

    If we take a trip back to the May timeframe you may recall that when Mr. Bernanke mentioned that the Fed may begin to taper QE3, 10-year treasury yields moved up over 100 basis points in a 2-month timeframe from 1.66% in early May to 2.73% in early July. Similarly, 30-year mortgage rates rose 100 basis points in the same timeframe from about 3.5% (early May) to about 4.5% (mid July). We then started seeing plenty of evidence that the housing market was stalling and the banks were laying-off folks in their mortgage lending operations in droves. Accordingly, a "no-Taper" announcement was made at the September meeting.

    From my perspective, I have a hard time reconciling a policy objective of supporting the housing market recovery, lowering the unemployment rate, increasing the labor participation rate, and fighting deflation by suddenly raising 30-year mortgage rates by 240 basis points. A lot of ink has been spilled on this subject, but one article you may want to consider is this one: www.forbes.com/sites/sharding/2013/11/01/its-still-too-early-to-worry-about-the-fed-tapering/; or this one by the same author: seekingalpha.com/article/1858771-the-fed-is-backed-into-a-corner

    While I believe the Fed would like QE to end, I believe they realize that ending the program overnight would also collapse the economic recovery overnight. We certainly may see a QE taper in the future, but I believe it will be combined with any number of policy tools to allow for an orderly scaling-down of the program without spiking treasury yields.

    Thus, I see two likely outcomes for Realty Income (and the REIT sector in general) moving forward: 1) interest rates remain low for a long period of time (i.e. the dreaded QE infinity); or 2) interest rates rise gradually normalizing to their historic mean over time (i.e. a managed end to QE implying a gradual increase in treasury yields to their historic 4.81%).

    Coming back to Realty Income, what this all means to me is that in order for Realty income to maintain its fair price of $40/share (based on the historic risk premium), it will need to pick up its pace of asset purchases and increase its dividend growth rate going forward. Whereas they may have acquired ~$500M in deals annually in the past (at a 1.5% spread to their cost of capital), they will begin doing around $1.5Bn or more in deals every year going forward.

    Consider that in 2013 alone, O acquired $1.24Bn in property acquisitions. seekingalpha.com/news-article/7910642-realty-income-completes-503-million-in-third-quarter-acquisitions; and seekingalpha.com/news-article/7012282-realty-income-completes-735-million-in-second-quarter-acquisitions

    Consider that John Case, their new CEO, has a transaction management pedigree from Wall Street. seekingalpha.com/news-article/7479902-realty-income-names-john-p-case-to-succeed-tom-a-lewis-as-chief-executive-officer

    Consider that on October 30th, the company exercised their $500M accordion option on their credit facility (while keeping all material terms constant) to give themselves $1.5Bn in "dry powder" to facilitate future acquisition activity and their EVP, Chief Financial Officer & Treasurer, Paul M. Meurer stated "This facility will provide us with the funds to continue to increase the size of our real estate portfolio, which is fundamental to our goal of regularly increasing the amount of the monthly dividend we pay to our shareholders." seekingalpha.com/news-article/7995922-realty-income-expands-credit-facility-to-1-5-billion

    Consider still that Management has an additional incentive to maintain a fair or high share price because it decreases O's cost of equity capital.

    In summary, today's price at ~$38 is at the lower-end of fair valuation based on the historic risk premium afforded to O. Similarly, based on a DCF valuation on the dividend stream, using a 9% discount rate and 6% dividend growth rate, O is at the lower end of fair valuation (see my prior blog post on this); alternatively using an 8% discount rate and 4.5% dividend growth rate, O is also at the lower end of fair valuation. However, these prices should not imply a margin of safety, as that would be any price at ~$28-$29 or below if the worst-case scenario occurred and treasury yields rapidly spiked up 200 basis points. It is up to the investor to determine which interest rate scenario is the most likely and proceed accordingly with their portfolio allocations and entry prices.

    For me, I like O as an income investment and have had a small position in my portfolio for the past few months as a hedge against low interest rates. However, based on my current analysis I am looking to make a larger investment at this time.

    ------------------------------------------

    As always, I take no responsibility for your investment decisions and you must perform your own due diligence. This data and any analysis are for informational purposes only and are intended to promote financial literacy.

    Best of luck to everyone on their investments.

    Palladium31

    Disclosure: I am long O.

    Additional disclosure: I have no other affiliation with the company and I wrote this post myself.

    Nov 29 3:05 PM | Link | 15 Comments
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