Jernigan Capital (NYSE:JCAP) takes the typical moderate growth business model of larger storage REIT peers like CubeSmart (NYSE:CUBE) and Public Storage (NYSE:PSA) and puts it on steroids. JCAP works with several partners that provide the equity investment to build new storage facilities. JCAP typically receives a "free" 49% equity stake in exchange for helping to select the location, arrange financing and provide project management expertise. This unique business model is described in more detail by author Tom Flannigan in his excellent recent article. This article will present 10 reasons to consider JCAP.
1. Outstanding management.
JCAP has a current market capitalization of only $118 million, but may have the best management in the entire storage REIT sector. Dean Jernigan was previously the CEO of CUBE and successfully transformed this storage giant. Tom Flannigan's article provides more color on Dean Jernigan's long and illustrious career in the storage business.
2. Other people's money.
I can't recall another company that uses other people's money this effectively. JCAP typically charges 6.9% interest to finance a storage project for 6 years. However, the windfall gains are due to the "free" equity stakes they are receiving in each new storage facility.
JCAP seeks to recycle its own capital as quickly as possible once an equity stake has been obtained. Ideally loans are refinanced well before the 6 year term ends. We saw one example of this in the Q3 earnings report:
"On October 18, 2016, the Company sold to a local Memphis, Tennessee-based community bank a senior participation in the construction loan of one of the Company's development property investments with a profits interest in Charlotte, North Carolina. The construction loan has a committed principal balance of approximately $6.8 million and earns interest at a rate of 6.9% per annum. Construction has been completed and a certificate of occupancy has been issued for this property. At closing, the bank paid to the Company approximately $3.4 million for the senior participation in the construction loan and will fund up to a total of $4.4 million as future draws are made on the construction loan."
3. Increasing book value.
JCAP went public at $20 per share on 3/27/2015 and initially traded lower. It took a few quarters for new storage projects to develop sufficiently for equity gains to begin driving book value higher. Book value increased by 74 cents per share in Q2 2016 and another 55 cents per share in Q3 2016. Many high yield stocks struggle to keep their book value from declining. JCAP achieved these significant and repeatable increases to book value while paying out a hefty quarterly dividend of 35 cents per share.
4. 15.2% return on capital in 2016.
JCAP has guided to generate adjusted earnings of about $2.50 per share in 2016. JCAP started out 2016 with a book value of $16.44 per share (see Q1 2016 earnings report). The $2.50 per share earnings will be a return on capital of $2.50 / $16.44 = 15.2%. A 15.2% return on capital would be very impressive for most companies, but JCAP did not really start to mature until Q2 2016. The balance sheet was grossly under leveraged for most of 2016. As of 12/31/2015 JCAP had $48 million in cash and no debt. Leverage has increased during 2016, but is still well below optimal levels.
5. A 20% return on capital is expected in 2017.
JCAP will be much more capital efficient in 2017. A cumulative preferred stock issue is being sold to Highland Capital to provide some additional balance leverage. Dean Jernigan believes that increasing leverage will add to book value and earnings. As he stated in the preferred stock press release linked above:
"The Company believes that the Highland commitment, together with proceeds from A note sales, will finance up to $200 million of additional self-storage development investments by the Company over the next several quarters, adding an estimated $8 to $10 to the Company's book value per share."
The company's expectations for a 20% return on capital was discussed by Dean Jernigan on the Q3 earnings conference call (see page #4):
"Therefore unless rates move backwards in a significant way, we continue to expect development yields on our portfolio to average greater than 9% and our internal rates of return to continue to track in the high-teens to the low 20% range"
Such high returns on capital are prized by investors. In fact there is a whole school of value investing known as "Magic Formula Investing" where high returns on capital are a key component of the screening process. This system was developed by famous investor Joel Greenblatt who authored "The Little Black Book That Still Beats The Market". This influential best seller is available cheaply in paperback and I highly recommend it.
6. Strong project pipeline.
JCAP has an exceptionally strong project pipeline as discussed by CEO Dean Jernigan on page #5 of the Q3 earnings conference call:
"This is a total of $152.3 million of development investments that we expect to close in the next three months. In addition, we have approximately $614 million of additional development investments in various stages of underwriting, and will continue to issue term sheets on a regular basis as our Investment Committee meets"
7. Significant insider ownership.
Insider ownership is detailed on page #22 of the 4/8/2016 proxy statement. Dean Jernigan owns 497,000 shares (I am including shares held by his wife).
8. Strong 1.8X dividend coverage.
JCAP pays a quarterly dividend of 35 cents per share and now yields 7.0% at a recent price of $19.90. With projected 2016 adjusted earnings of $2.50 per share, the dividend coverage is 2.50 / 1.40 = 1.8X. The dividend is very well covered using 2016 adjusted earnings. I believe that 2017 adjusted earnings are likely to be considerably higher due to favorable market conditions and an increase in balance sheet leverage. We may see a 2017 dividend increase.
9. Low current valuation.
At a recent price of $19.90, JCAP is trading at only 1.1X the $17.59 book value and 8X 2016 adjusted earnings. This is remarkably cheap for a growth stock that is generating such high returns on capital.
10. My $42 price target.
I am using a 2017 adjusted earnings estimate of $3 as compared to 2016 adjusted earnings of $2.50. This estimate may be conservative given the strong project pipeline, favorable current market conditions and planned increase to balance sheet leverage.
Multiples are very high for larger peers in the storage REIT sector. CUBE is now trading at 15X trailing EBIDTA and PSA is trading at 20X trailing EBIDTA. Even with JCAP's far superior growth, I am using a lower multiple of 14X adjusted earnings to reflect it's smaller size. My 1 year price target for JCAP based on 14X adjusted 2017 earnings is therefore $42
What are the major risks?
A recession would hurt the storage sector. Over-building is also a concern for certain markets. Jernigan has used his expertise to minimize this risk by cherry picking the best projects to invest in. While Jernigan has been building an effective team, his loss or departure would be a significant blow to the company. The new preferred stock being issued to Highland Capital is expensive. The terms are complex, but Highland Capital is guaranteed a 14% IRR under most circumstances. Such expensive capital would be a red flag if JCAP were not generating an even higher return on capital itself and also selling some lower cost notes.
JCAP offers a remarkable combination of qualities including rapid growth, great management, high returns on capital and increasing book value. Very few high yield issues are this dynamic. Unless we hit an economic downturn in 2017, JCAP has the potential to double in price and the dividend may be increased.
Note: My Panick Value Research Report is focused on high-yield preferred stocks, exchange traded debt issues and other undervalued high-yield opportunities. Members receive an advance look at all my articles as well as continued coverage. JCAP was added as an equity pick on 11/22/2016 at $18.57. Readers are invited to check out the 2-week free trial in the Seeking Alpha Marketplace. Subscriber reviews can be viewed here.
Disclosure: I am/we are long JCAP.
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.