A Strong Buy We Love - And Kimco Is Its Name-O

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About: Kimco Realty Corporation (KIM)
by: Brad Thomas
Summary

When you have a good REIT on your hands, you can just sit back and collect a growing dividend stream.

You need to focus on quality first and then valuation.

And last but not least, you need to have enough patience for the long-term thesis to play out.

This article was co-produced with Dividend Sensei.

History has shown that owning real estate, in general, is an advisable way to earn both great income and excellent total returns. And when it comes to investing in real estate, in particular, decades of data show that real estate investment trusts - more commonly known as REITs - are hands-down the best way for people to profit from what's essentially a utility for the broader U.S. economy.

(Source: NAREIT)

REITs don't just offer you more diversification than what naturally comes from investing in commercial properties. They also come with instant liquidity you won't get from buying up commercial buildings, which can take months or even years to sell… and sometimes include 6% closing costs on both ends of the transaction.

Plus, with REITs, there are management teams in place that do all the work for you. Investors just sit back and collect their growing dividend streams.

That is, when you have a good REIT on your hands, you can just sit back and collect a growing dividend stream. You need to focus on quality first and then valuation. And last but not least, you need to have enough patience for the long-term thesis to play out.

Since, sometimes, the markets don't catch on very well about a position's potential.

(Source: Ycharts)

With that in mind, let's look at Kimco Realty (KIM), one of America's largest shopping center REITs. After a year-long bull market, it's finally getting the love that I have been saying it deserves for a while now.

The stock has been red-hot, soaring over 30% off of December's lows. For that matter, it's outpaced the broader REIT sector and even the tech-heavy S&P 500.

For so many reasons, I consider Kimco to be a 6%-yielding blue-chip worthy of consideration for your diversified income portfolio. For one, even after a 30% rally, this REIT is still about 19% undervalued. And, when combined with its long-term cash flow and around 4% dividend growth potential…

It's still capable of delivering close to 13% annualized total returns over the next five years.

Kimco Realty: Risen From the Ashes to Become a Blue-Chip Phoenix

The financial crisis was brutal for most REITs, with 87% of them having to cut or suspend their dividends. Kimco among them.

(Source: FRT investor presentation)

To be sure, Kimco made some huge mistakes in the runup to the crisis. As a result, it had to slash its dividend 57%.

Those mistakes included using a ton of debt to grow into low-quality U.S. markets just for growth's sake. And then there were more empire-building misadventures into Canada, Brazil, Mexico, Chile, and Peru.

The result was that the REIT's leverage ratio (debt to earnings before interest, taxes, depreciation, and amortization - i.e., EBITDA) peaked at 12 and then some.

That's not good.

(Source: Ycharts)

Now, I won't lie to you and say Kimco has become the highest-quality shopping center REIT you can buy today. That distinction will likely always fall to Federal Realty Trust (FRT). On my 11-point quality scale, FRT is 10, not to mention the only Dividend King in all of REIT-dom.

Even so, Kimco's impressive turnaround has helped transform it into a level-8 quality blue-chip… one that's made an impressive turnaround over the past decade that Wall Street still doesn't fully appreciate.

The key to its comeback was management grasping the full importance of featuring a strong balance sheet and focusing on quality over quantity. Over the past few years, it's sold off all its international properties to focus exclusively on the U.S.

(Source: Kimco investor presentation)

But Kimco isn't focusing on just on any U.S. market. It's cleaning house here too. Back in 2010, it owned 816 properties in many secondary and tertiary markets. But it's spent the past few years selling off those lower-profitability sites to focus on the most lucrative markets exclusively.

(Source: investor presentation)

Today Kimco owns just 430 shopping centers. Their average quality is much higher than before, and they're mostly located inside of primary markets within America's most affluent 20 cities. In fact, 81% of its rent is from the 20 largest markets, with 78% coming from the sunbelt. Note how that region's population is expected to grow by 6.3 million within five years.

Then expand the Kimco picture out a bit further. When you do, you'll find that 96% of its rent comes from America's 40 largest, most affluent, and fastest-growing cities.

(Source: earnings supplement)

All told, its properties have 7,900 leases signed with 3,700 tenants. Better yet, it's well diversified, with just 13 companies representing 1% or more of the REIT's rent.

(Source: earnings supplement)

That's part of Kimco's "Vision 2020" strategy, which is now almost complete. It's a focus on retaining just its top market properties and reinvesting in them to increase their value. This would be via densification projects that boost occupancy and sales per square foot.

Most importantly for any REIT, the company is building and maintaining a very strong balance sheet. This way, it will have access to plentiful low-cost capital, which is the lifeblood of the sector.

Kimco's overall strategy is about adapting to the future of retail, including by prioritizing retailers who are thriving in the world of "bricks and clicks" omnichannel marketing. Ninety-six percent of its rent is from either e-commerce-resistant services or proven omnichannel winners.

(Source: investor presentation)

That latter category includes champs like:

  • Walmart (WMT), which is rolling out in-store pickup and delivery services to 2,100 stores by the end of 2019. This will cover a full 40% of the U.S. population.
  • Chipotle (CMG), whose online ordering sales are growing at 48% annually.
  • DSW, where 50% of its locations are now used for digital sales fulfillment. That number is expected to rise to 75%-90% by 2024.
  • Target (TGT), which is seeing 75% of its online sales fulfilled from physical locations.
  • Home Depot (HD), where it's boasting 48% of its online orders being picked up from physical stores.
  • Starbucks (SBUX), where mobile payments for in-store pickup make up 40% of U.S. sales.

(Source: investor presentation)

Plus, the plurality of Kimco's new leases is being signed with service-oriented tenants who represent less risk of being disrupted by the likes of Amazon (AMZN). Those include thriving businesses focused on off-price beauty, fitness, restaurants, and medical services.

Meanwhile, 77% of its rent is from centers that are anchored by grocery stores - another important category that makes up 14% of rent. This means that much of Kimco's cash flow has a built-in cushion during any future recessions.

Its average lease has 6.8 years remaining. And through 2030, the highest lease expiration year is 2021… when just 12.3% of leases will expire. Basically, that means Kimco enjoys a very stable cash flow from which to pay its generous and safe dividend.

Of course, though, the big reason I'm bullish on Kimco is due to the huge quality-centered improvements it's made to its property portfolio. How can you tell this is true? By looking at the REIT's core fundamental stats…

  • Occupancy: 96%, with the highest Q1 occupancy its seen in 10 years.
  • New Lease Spreads: 17.4% - which, incidentally, means it's gone 21 consecutive quarters of double-digit spreads now. It also follows 2018's 12.8% lease spreads.
  • Same-Store Net Operating Income (SS NOI): up 3.7%, after 2.9% growth in 2018.

In case you didn't know, lease spreads are how much more rent a company can get after existing leases expire. So, as evidenced by the numbers above, Kimco's core properties are generating steadily higher revenues.

Moreover, double-digit lease spreads are a key sign that its properties are high-quality, well-situated and able to attract thriving tenants. And management estimates that its average existing lease is for rents that are 31% below market rates. That, in turn, means Kimco should continue to enjoy strong lease spreads and growing SS NOI for the foreseeable future.

To help drive strong organic growth, the REIT is focusing most of its investments on improving its existing properties. Since 2015, it's completed 78 of these projects for $375 million, earning a 10% average return on investment along the way.

In 2018, that included 28 projects it expects will earn long-term returns of 10.9% on invested capital. Compare that to historical 7.5% cash yields on new properties and a 6% cost of capital.

(Source: investor presentation)

This REIT has a $774 million backlog of projects it's planning to complete by 2021. Once all that has stabilized, it's expected to generate returns of 6% to 13.5%.

Two of these are brand-new centers located in thriving Ft. Lauderdale and Baltimore suburbs (Dania Beach, Florida; and Owings Mills, Maryland).

(Source for both charts: investor presentation)

Beyond 2021, the REIT has 29 projects in its shadow backlog. This potentially includes constructing over 6,000 apartments to increase the density, foot traffic, and value of its properties.

Now, that's a long-term backlog, especially considering how projects could take 10 years to complete. But note that Kimco is also planning hotels and office buildings… with many of its future developments being built in red-hot real estate markets like D.C., New York, and Boston.

Of course, a grand growth plan is worthless without access to low-cost capital. But Kimco has that in spades too. A whopping 98% of its debt is fixed-rate with an average maturity of 10.5 years - one of the longest in the sector - and an average 3.6% interest rate. That low borrowing cost, locked in for over a decade, is explained by Kimco's BBB+ credit rating. Which will likely get upgraded to A- one of these days.

Kimco's balance sheet is so strong that it could borrow up to $3.7 billion before it would risk violating its bond covenants. Either that or its consolidated net income would need to decline 78%, which would amount to $870 million.

And it only fell 59% in 2009.

(Source: investor presentation)

Kimco has just 30% of that debt coming due over the next four years, with none maturing this year. It also has $2.3 billion in liquidity right now thanks to cash and remaining credit revolvers. And it doesn't actually need to tap most of that any time soon.

Much of the REIT's growth plans have been financed via capital recycling. This includes 76 asset sales in 2018, which totaled $918 million.

2019 is expected to be the final year of net asset sales, with $250 million planned.

(Source: earnings release)

In Q1, it saw $95 million in dispositions. This puts it ahead of schedule to complete that final year of net asset sales. After that, it should begin growing funds from operations (FFO)/share again in 2020 and 2021. Analysts expect that to happen at a 3% rate.

(Source: F.A.S.T. Graphs)

Over the long-term, analysts expect Kimco to deliver about 4% FFO/share and dividend growth. Since that's roughly average for a REIT, this level of growth might not sound like much. However, combined with Kimco's safe 6.2% yield and attractive valuation…

It's potentially good enough to deliver double-digit long-term returns.

Double-Digit Total Return Potential, Courtesy of a Generous and Safe Dividend

I highly value positions that are designed to generate market-beating long-term returns via a combination of safe yields, long-term growth potential, and valuations returning to historical fair value. And that's what typically happens with dividends stocks and especially REITs.

Here are Kimco's current stats:

  • Yield: 6.2% (vs. a 4.2% 5-year average and a 5.3% median for REITs)
  • FFO Payout Ratio: 77% (81% sector average, where 90% is the maximum safe limit)
  • Debt/Adjusted EBITDA: 5.7 (vs. a 5.8 sector average)
  • Interest Coverage: 4.5 (vs. a 3.4 sector average)
  • S&P Credit Rating: BBB+
  • Average Interest Rate: 3.6%
  • Dividend Safety: 4/5
  • Sensei Quality Score: 8/11 (Blue-Chip).

My blue-chip classification is based on a proprietary quality score that considers dividend safety and business model. It also factors in management quality, such as it's capital allocation track record and dividend friendliness.

Under this system of evaluation, all Kimco needs to make it a level-9 quality position would be a credit upgrade.

Until then, here are some other numbers to consider:

  • Expected Long-Term FFO/Share Growth (Analyst Consensus): 4%
  • Expected Total Return (no valuation change): 10.2%
  • Approximate Discount to Fair Value: 19%
  • Valuation-Adjusted Return Potential: 12.6%.

With a realistic 4% long-term cash flow growth rate - which the dividend should track over time - that gives Kimco roughly a potential 10% long-term compound annual growth rate (CAGR) total return, assuming that the valuation remains constant. That's superior to the S&P 500's historical 9.1% and much better than the roughly 4% asset managers expect from the market over the next five to 10 years (per Morningstar's 2019 long-term return survey).

However, Kimco's valuation (specifically its price/FFO) isn't likely to stay put. Not if management delivers on its growth plans. And so far, its execution has been very good.

(Source: F.A.S.T. Graphs)

Since the Kimco turnaround began in 2010, the REIT has grown FFO/share by 5.4% CAGR. It's also enjoyed an average P/FFO of 15.3.

With analysts expecting 4% long-term growth… which I consider reasonable given the growth backlog… I consider 15 a reasonable forward-cash-flow multiple. That's based on long-term interest rates remaining relatively steady in the future due to demographic and secular economic headwinds that should prevent inflation from rising much higher.

If Kimco indeed roughly achieves its historical multiple in five years, that would translate into nearly 13% CAGR five-year returns. For a high-yield blue-chip, that's strong enough to make Kimco a "Strong Buy" in my book.

Of course, that's only if you're comfortable with the REIT's short-term risk profile. And if you own it as part of a diversified and well-constructed portfolio.

Risks to Keep in Mind

As already mentioned, Kimco's business model is focused on shopping centers anchored by grocery stores. This does mean it's more recession-resistant than other retail REITs, such as malls.

However, we also have to consider the potential damage that the escalating trade war with China could cause to the U.S. economy in general and retailers in particular… retail REITs and all.

(Source: FRT investor presentation)

On May 10, U.S. tariffs on $200 billion in Chinese imports were raised from 10% to 25%. The Chinese have since retaliated via 5%-25% tariffs on 91% of U.S. imports. And the U.S. has started the process of imposing 25% tariffs on all remaining Chinese imports - which U.S. Trade Representative Robert Lightheizer estimates is about $300 billion worth of goods.

Up until now, tariffs have been mostly on intermediate goods. However, these remaining ones will be on things like electronics and apparel. In which case, no retailer is going to be spared the pain.

What the Final Rounds of Tariffs Will Affect

(Source: National Retail Federation)

Keep in mind that 25% tariffs are simply too great for Chinese manufacturers to eat. Their operating margins just aren't that high. And U.S. retailers have a median operating margin of 2.9% since omnichannel operations are expensive and currently depressing profitability. This means that nearly all of those 25% potential tariffs will have to be passed onto consumers. And that, of course, could badly damage the economy and overall retail sales.

Estimates on how much vary, between $767 and $2,294 per year in extra costs per average US family of four. However, given that, according to the US Census Bureau, median US household income is $59,000 per year, this means that 25% tariffs on all Chinese imports could cost the typical American family 1.3% to 3.9% of their income.

Not just might that stoke inflation, but it's likely to significantly decrease retail sales, which would be bad for Kimco, and all retail REITs. New tariffs require a 90 day comment period once the final list is released, meaning that the final round of tariffs could go into effect in August or September, should a deal not be reached by then.

Moody Analytics estimates that full US tariffs on China would reduce US employment by 3 million by the end of 2020 (average of 167,000 per month in job losses), and reduce GDP by 2.6% by the end of next year. Given that economists expect about 2% GDP growth next year, this means that a full-blown trade war could put the US into a mild recession. Average net job growth this year is 163,000 so tariff damage might take that to zero or slightly negative.

According to the WSJ, the US requires about 145K in net job creation per month to keep up with population growth and keep unemployment stable (and prevent wage growth from declining). Should Moody's economic model prove generally accurate (none are 100% correct) then rising US unemployment and falling wage growth could hurt consumer and business sentiment creating the conditions necessary for a recession to begin in 2020 or 2021.

(Sources: Cleveland and New York Federal Reserves)

According to the Cleveland and NY Fed recession models, before the trade war escalated in early May, 12-month recession probability was between 27% and 31%. That was the highest it's been in a decade and the short-term shock of the tariffs going into effect (with 1-week notice) could be enough to boost that risk to 35% to 40%. That might not sound like much of a difference, however, the peak 12-month risk before the three previous recessions ranged from 35% to 50%.

While historical macro analysis can't be used to predict what will happen with precision, the point is that the next few months could be the deciding factor in whether the longest economic expansion in US history (as of July 1st, 2019) continues or ends relatively soon.

Does that mean you should avoid buying undervalued Kimco today (and rush out and sell all your stocks ahead of a recession and bear market?) Absolutely not.

Remember that all investing is probabilistic and you can never be 100% sure that anything will happen. No less than Peter Lynch, the second greatest investor in history (29% CAGR total returns from 1977 to 1990) said

"In this business, if you're good, you're right six times out of ten...Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections than has been lost in corrections themselves." - Peter Lynch (emphasis added)

Decades of market data back up Lynch, because as JPMorgan Asset Management points out, the average investor's total returns over the past 20 years (due almost entirely to market timing) was a pitiful 1.9% CAGR.

That's worse than inflation, and also every single asset class you could have owned. In contrast a 60/40 stock/bond portfolio nearly matched the market and even a super conservative 40/60 stock/bond portfolio did nearly three times better than the typical retail investor trying to time market corrections and rallies.

This is why I keep pounding the table about proper risk management and asset allocation.

No dividend stock, not even a blue-chip, is a cash/bond alternative. If you need to sell assets periodically to pay the bills (like retirees on the 4% rule in a correction/bear market) that's where cash (t-bills) and bonds come in.

Bonds are a separate asset class that in the modern era (of low inflation and historically low interest rates) tend to be countercyclical to stocks. Which is why, during a bear market, cash and bonds tend to remain stable or appreciate in value.

All of my recommendations are ONLY for the equity portion of your portfolio and meant to be part of a well-diversified stock portfolio at that. Never forget that all stocks are "risk-assets" and almost all fall during a bear market (which, since WWII, has always occurred during recessions).

Even the famous dividend aristocrats and kings didn't avoid losses during the Great Recession (just three out of 81 managed to avoid negative total returns and the biggest winner was Walmart at +7% including dividends).

Bottom Line: Kimco Likely Still Has Room To Run After Its 30% Rally Of December's Lows

Despite what the media likes to claim there is no "retail apocalypse" merely the natural creative destruction generated by the natural need to adapt to changing consumer tastes over time (management estimates over 5,500 store opening in the US this year).

Kimco has shown itself to be highly adaptable, as exemplified by the fantastic improvement in its balance sheet, its core property stats (which prove its properties are high-quality and thriving) and its long-term growth plan which is holistic and focused on maximizing the value of its property base.

I consider Kimco a solid high-yield blue-chip, whose impressive turnaround is nearly complete. That should cause cash flow to start growing next year and accelerate to about 4% long-term cash flow and dividend growth in 2022 and beyond.

Despite a 30% rally in recent months Kimco is about 19% undervalued and should be able to deliver close to 13% long-term returns over the coming five years. Just make sure to take into account the temporary pain that a full-blown trade war with China might cause for all retailers (possibly starting in August or September) and size your position accordingly.

And never forget that no dividend stock is a true bond alternative, which is why proper asset allocation for your risk profile is crucial to achieving your long-term financial goals. Now you know why we titled the article: "A Strong Buy To Love - And Kimco Is Its Name-O." Photo Source

Author's note: Brad Thomas is a Wall Street writer, and that means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free, and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking.

Disclosure: I am/we are long KIM. 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.