No One Likes Wheeler But The Preferred Pays 11%

Summary

• All of the criticisms of Wheeler and management are valid.
• Its common stock is too risky right now and possibly overvalued even though Bloomberg consensus price targets are 30% above current levels.
• These target prices will probably come down after analysts update their models post earnings call.
• The Preferred class D, however, pays an 11% yield to call with a step-up in dividends if not called by 2023.

Subscribers got a first look at this article when it was first published in Marketplace on June 29th. The Strategic Income Growth Portfolio has a 3% allocation.

Summary/Introduction

Sometimes when you’re looking for attractive investment opportunities, you have to go to places where few others go - and I mean in the middle of nowhere - or what some folks might call the boonies! Have you ever driven through the boonies? I don’t mean to insult anyone that lives in rural America, but when I was first going to college, I enrolled at Troy State University in Troy, Alabama. I had never been there and had never lived outside Miami at that point. The plan was to walk-on to the baseball team, which at the time was one of the best Division II programs in the nation. I was a good ball player, but I knew I couldn’t make it onto a Division 1 team. In hindsight, I probably wouldn’t have made the Troy team either.

The point I’m getting to is that as I was driving up to Troy for my first semester of college, I was driving up highway 231 when I had finally arrived - a sign that said "Welcome to Troy". As I kept driving while looking for other signs pointing me towards the school, it wasn’t long before I saw another sign - "Now Leaving Troy, Thank you for visiting". "Wow", I said to myself, "what have I have gotten myself into?" To make a long-story short, I found the school, drove around Troy to check the place out for all of 30 minutes - that was enough to go around town three times - and then I turned around and went home. After driving for 24 hours straight, I was back home in my own bed, in a big city that you can’t drive through without noticing the big skyscrapers. Back then, Troy was the epitome of the boonies for me. It’s a great little town, just not for me at the time.

Today I find myself going back to the boonies, figuratively speaking, to find an investment opportunity for both the Heard on the REITs and Strategic Income Growth portfolios.

Investment Thesis

Shopping center REITs have been banged up with the rise of online shopping and the likes of Amazon (AMZN) scaring investors to death into thinking all brick and mortar shopping places are going to disappear. This may eventually be true but at least when it comes to local grocery stores, that could take a while, particularly in rural areas where consumers are more inclined to shop in-store rather than have their food delivered. The entry of Amazon into the grocery business with the acquisition of Whole Foods (WFM) might be cause for concern for many grocery store chains. But the folks that shop on Amazon and Whole Foods are not the same folks that shop at places like BI-LO, Winn-Dixie, Dollar General (DG), and Family Dollar (FDO). It’s a different demographic and in rural areas; the grocery delivery model will be much harder to scale profitably.

That is why I like Wheeler Real Estate Investment Trust (NASDAQ:WHLR) and its 13% dividend yield. It’s what caught my attention to begin with. However, after careful analysis, I decided the common stock was too risky for my conservative income portfolio but thought that the preferred shares offered a decent yield with much less risk than the common. Specifically, the Wheeler Real Estate Investment Trust Preferred D (WHLRD) because of its 11% yield to call, and the 2% step up in dividends if not called by 2023.

Industry Analysis

The shopping center business is driven by retail sales and many shopping centers must compete for consumer dollars with the large regional malls and the independent shops. Naturally, the shopping centers are places where consumers go for quick purchases, services like haircuts and tire changes, as well as a few other things that frankly are not worth a trip to the mall. The successful shopping centers tend to be near high density and high income households where the average sales per square foot are high. But people who live in rural areas also have to eat - and buy food and other products. For them, a quick trip to the local shopping center is a convenient alternative - particularly when they need to buy food and groceries.

For this reason, I’m going to focus primarily on analyzing the grocery industry as a driver of shopping center success rather than focus on the dynamic between shopping centers and regional malls.

The successful shopping center REITs are increasingly highlighting their grocery-anchored properties. The grocery business in turn is highly competitive and has razor-thin margins. Not only can you buy your groceries at the neighborhood store, but also you can go to Wal-Mart (WMT), Target (TGT), convenience stores, and warehouse discount stores like Costco (COST) to name a few. Some of these companies have stores in shopping centers so any market share they take from traditional grocery stores isn’t a total loss for shopping centers - only the ones whose tenants are grocery stores.

Growth in the industry is quite boring, frankly. It is considered high when it exceeds the level of inflation. For example, grocery stores have experienced a 23-year compounded annual growth rate (CAGR) of 2.7% through 2015. As I said, uninspiring. Most of this growth came from volume increases from higher consumer spending and population growth, with additional growth coming from food price inflation. In other words, there isn’t a whole lot of "innovation" in the industry. On the other hand, even during recessions, grocery sales hold up pretty well even if growth does slow a bit, so stocks in the sector tend to hold up well in a downturn. (See chart below):

One of the factors that has limited the long-term grocery sales trend, however, is the recent shift from food-at-home (grocery) to food-away-from-home (foodservice). This has benefited malls and shopping centers that have refocused on service-based tenants (a good thing for our shopping center REITs with restaurants). There has also been an increase in consumer preferences for lower-priced private-label products, and greater pricing competition with a shift in sales from traditional formats to lower-priced discount formats (i.e. Costco, Family Dollar, etc.).

Not surprisingly, the driver of consumers eating at home versus eating out is economic prosperity. For example, consumer food expenditures at home peaked in 2011 at 54.7% after the recession drove many consumers to be more frugal. In 2016, however, spending on food consumed at home dropped to just 49.4% of total food expenditures, as unemployment declined and wages grew (albeit slowly) - leading consumers to eat out more. In the short term, this trend is expected to continue but could reverse again when economic growth slows.

The Entry of Lidl

Recently, Lidl, a small-store format grocer out of Germany that offers high quality and low prices with a high percentage of locally and regionally provided products, announced its intent to open 100 stores in the US. In a presentation, it calls itself a cross between Trader Joe’s and Harris Teeter. I mention it because when combined with Aldi - which currently has over 1,500 stores in the US with plans to open another 600 - could create yet another shift in the grocery-anchored shopping center marketplace. Both of these stores use smaller spaces than even traditional grocery stores, and although Aldi has very few stores in areas where Wheeler owns property, it would be to Wheeler’s benefit to establish a relationship with Aldi as it expands into the Southeast Bible Belt. The same holds true for Lidl, which is opening its first stores in the Southeast region.

Both of these stores will compete directly with existing grocers which will inevitable result in price competition and additional closures of unprofitable stores. But for shopping center REITs, it offers a strong new tenant with aggressive growth plans.

Wheeler Business Description/Business Model

Wheeler is a commercial REIT that acquires and manages necessity based, grocery-anchored centers in secondary and tertiary markets with specific demographic characteristics. For example, Wheeler’s properties are located in lower population-density areas that typically have lower competition. The average property has 10 surrounding grocers and 10,000 households within a three-mile radius, which differs from peers which have properties with 15 to 30 surrounding grocers and 20,000 to 40,000 households within a three-mile radius. The chart below highlights the extreme rural locations of Wheeler’s properties relative to the broader peer group:

Source: Wheeler May 2017 Presentation

It currently has a portfolio of 74 properties with national and regional tenants focused primarily on lower income target markets. The top 10 tenants are shown below and I’d like to point out that BI-LO and Winn-Dixie are brands owned by Southeastern Grocers, so Wheeler’s exposure to them is over 15% of ABR. The rest of the top 10 are other grocery stores with the discount dollar stores rounding out the bottom 2.

Source: Wheeler May 2017 Presentation

The company is recycling its portfolio to increase the quality of the properties owned - selling six properties successfully in 2015 and leading to an aggressive acquisition strategy - acquiring 23 properties in 2016 - which may have been more than the company could profitably integrate - but which are just beginning to show signs of improvement.

As the map below shows, all of Wheeler’s properties are located in the Southeast and Atlantic states with the majority in South Carolina and Georgia.

Being the smallest shopping center REIT is a disadvantage for Wheeler in many respects but its strategy to locate properties in - the boonies - has helped isolate it from heavy competition. That being said, there are both opportunities and challenges faced by the company that I highlight below in the SWOT analysis.

Performance Drivers

The company has been an underperformer historically and has mostly paid out dividends in excess of funds from operations. However, the trend witnessed in the last two quarters indicates that it is heading in the right direction, having reduced general and administrative expenses from 29% of total revenues in 2Q2015 to 9% in 1Q2017. Unfortunately, adjusted funds from operations also declined over this period and only last quarter showed signs of reversing the downward trend.

Source: Wheeler May 2017 Presentation

Looking towards 2017, the company has provided guidance of $1.48 to $1.55 per share and reiterated this guidance as recently as June 1st. But the guidance has already been reduced twice from its original estimate of $1.68 to $1.73 per share. The revisions do make me feel uncomfortable, but I still find the revised guidance to indicate the company is moving in the right direction.

Source: Wheeler May 2017 Presentation

One of the indicative metrics of a property owner’s risk is the number of tenants with rent/sales ratios above an amount that prevents the tenant from remaining profitable, particularly in the low margin grocery business. As the chart below shows, 61% of grocery tenants at Wheeler properties have a rent/sales ratio of less than 3% - the industry benchmark for a "healthy" rent payment in relation to sales. The downside and risk for Wheeler is that 23% of its grocery tenants have a ratio above the very dangerous level of 4%.

Source: Wheeler May 2017 Presentation

As I was analyzing the company and figuring out whether I was comfortable with the inherent risk of a small shopping center REIT with less than investment grade tenants in the middle of nowhere, I decided to analyze two potential risks. The table below lists the properties anchored by BI-LO, the square footage of those stores, location, major employer in the town, and the proximity to the closest Wal-Mart. One of the risks I wanted to analyze is the risk of a Wal-Mart entering or already in the vicinity taking market share and causing distress that leads to store closures for Wheeler’s tenants.

As the table shows in the far right column, there are a few Wheeler properties with Wal-Marts not far away - in one case less than one mile. But there are also properties whose nearest Wal-Mart is far enough not necessarily to deter consumers from going to Wal-Mart, but far enough that many consumers will still have a need to visit the local grocery store. The median distance between the properties shown and nearest Wal-Mart is 5.1 miles.

The second risk I wanted to analyze is the potential loss of jobs due to a major employer closing its offices in the area. A review of the list of major employers in each of the locations shown below indicates that there really isn’t a major employer, whose viability is critical to the economic success of the town. Only Gulfstream, with over 9,000 employees stands out as a potential risk.

Source: Orenda Partners, Wheeler Website

Peer Comparison

On an YTD basis, Wheeler’s stock has suffered declines just like all other shopping center REITs, with a decline of 21.6% YTD, slightly worse than the peer median. It does, however, look pricey and a P/FFO basis compared to peers when looking at the most recent 12 months of FFO; as mentioned earlier, it only recently started generating positive FFO. However, with an expected FFO growth of 174% to $1.29 (a slightly lower estimate than management guidance), Wheeler’s forward P/FFO drops to a much more reasonable 8.2. It’s a great reversal but if the expected dividend is $1.36, it is still not covering its common dividend with its FFO. We suspect, therefore, that if management has to reduce FFO estimates again, there will likely be another dividend cut.

Source: Bloomberg, Orenda Partners

Financial Statements Analysis

Financial Stability

The company currently has $4.6M in cash + $7M in revolver credit which could alleviate cash flow shortfalls in case of missing FFO targets in the near future. However, the balance sheet is highly leveraged with EBITDA coverage of 1.7x compared to peers of 2.5x or greater.

Management has stated its commitment to improving its capital structure and reducing debt and fixed charges. Following this trend of increasing revenues and lowering debt, if implemented successfully, should significantly improve its coverage ratio in the 2017 and 2018.

Balance Sheet

Source: Thomson Reuters

Earnings/Cash Flow Stability

I have already mentioned that FFO has only recently turned positive with management guidance that although lacking in total credibility is much better than last year’s results. What I’d like to highlight in the income statement below is that revenues have almost doubled from 2015 to 2016 while SG&A remained flat.

Net operating income - which is not shown below - increased by 63.8% to $9.9 million while FFO increased 50% YoY to $0.15 per share. The fifth year out of the last six years in which FFO was positive and results seem to confirm a stabilizing FFO.

Income Statement

Source: Thomson Reuters

Cash Flow Statement

For the first time since 2011, the company had positive cash flow from operations. That could be tangentially used as a proxy for FFO, however, it still had to issue additional stock to fund the acquisitions.

Source: Thomson Reuters

Ratio Analysis

It’s not surprising that Wheeler does not compare favorably with many of its larger peers. It is not as financially stable and has not generated FFO in line with its peers. It has, however, invested considerably more on a percentage of revenue than its peers which has been mentioned before.

Source: Bloomberg

Preferred Dividend Sustainability

While I am not comfortable owning the common share nor whether the current dividend could be maintained, I see value in holding the Preferred Shares, specifically the Pref D class, which currently has a yield to call of 11% and a step-up of 2% in the dividend if not called by 2023. The shares have recently recovered during the time we were analyzing the company, but still think it is a good buy at $23 or so.

• WHLRP (Class B): $25 Preferred convertible share with a 9% coupon that pays dividends quarterly. It has a daily trading volume of 5,000 shares.
• WHLRD (Class D): $25 Preferred convertible share with 8.875% coupon that pays dividends quarterly. It may be called at par starting 2021. It has a daily trading volume 20,000 shares.

Other Terms:

• WHLRD may be called at par starting 9/21/2021, with a failure to redeem clause starting 2023 as stated above.
• Put option 2023 clause: Option to convert preferred shares at par into common stock.
• Protective leverage covenant: Company will need to redeem or partially redeem shares if asset coverage ratio drops below 200%. As of December 31, 2016, Wheeler had a coverage ratio of 284%. By consequence we don’t think the firm is at risk of violating the protective leverage covenant in the medium term.

At the moment, the company is approaching levels that would cover the common dividends. This would correspond to a preferred dividend coverage ratio of 2.6x - another reason I feel a certain level of comfort holding the preferred share. While it has reduced common dividends in the past, it has never failed to pay a preferred dividend.

Source: Wheeler May 2017 Presentation

Risks

• Approximately 9.9% of the company’s gross leasable area (GLA) is subject to leases that expire during the 12 months ending March 31, 2018. 63.3% of the leases expiring have options to renew and are expected to do so at terms comparable to existing lease agreements based on market trends.
• Two BI-LO stores closing that will affect Q3 2017.
• Management - History of wrong earnings estimations due to misinterpretation of expenses/revenues. For Q1 2017, Wheeler reported AFFO per share of $0.31, below its guidance of $0.36 to $0.38. This was due to higher than expected seasonal property and corporate expenses. Management guided $0.045 per share of seasonal costs which ended up being $0.075 per share mostly because of higher snow removal costs caused by harsh weather. In Q1 2017, Wheeler adjusted its AFFO guidance from $1.68 to $1.73 per share to $1.64 to $1.68 to account for higher costs in the first quarter and to allow for more conservative leasing and fee assumptions. Only 20 days after the first adjustment, Wheeler reaffirmed second-quarter AFFO of $0.40 to $0.42 per share but it adjusted its full-year guidance again to $1.48 to $1.55 per share.

Summary

It is hard to ignore an 11% yield on a preferred stock. It certainly isn’t a position I would recommend to all investors at least not for as a big part of a portfolio. But when a company seems to be turning things around and the dividends payable to the preferred are cumulative - and which the company has never failed to pay - it’s worth a small allocation for yield enhancement and, usually, lower volatility. Although this particular preferred has been volatile in the past. I expect the vol to decline as the company improves performance, and at least over the last month, the market seems to be giving management the benefit of the doubt.

Disclaimer: Please note, this article is meant to identify an idea for further research and analysis and should not be taken as a recommendation to invest. It is intended only to provide information to interested parties. Readers should carefully consider their own investment objectives, risk tolerance, time horizon, tax situation, liquidity needs, and concentration levels, or contact their advisor to determine if any ideas presented here are appropriate for their unique circumstances.

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Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I am/we are long WHLRD. 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.

Long WHLR