Spirit Is No Longer Spooky

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About: Spirit Realty Capital, Inc. (SRC)
by: Brad Thomas
Summary

As a REIT analyst, it’s my job to mine for gems.

Spirit is now free of its overhang as the company has announced that it has broken free from the “legacy spirits” (pun intended).

We are upgrading Spirit to a strong buy and we are reiterating our strong sell for Hospitality Property Trust.

One of my best calls last year was Essential Properties Realty Trust (EPRT) in which I initiated a Strong Buy "based on the favorable risk management practices and discounted valuation". As a net lease developer (for over 20 years) with deep experience in the sector, I knew that this particular REIT was poised to profit. Since my article (on December 18, 2018) shares have returned over 53% (boom!).

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Source: Yahoo Finance

OK. I know what you're thinking…most REITs were up in 2019…but not 53%...

But what about May 2017 when I decided to upgrade shares in Store Capital (STOR) from a buy to a strong buy? In that article I explained,

"STOR's approach is more of a risk management one, and so, instead of herding hundreds of Net Lease deals through the door every year (like many of its peers), the company takes a more granular approach to ensure there is a critical piece of real estate attached to a profitable business operation."

What's interesting, if not extraordinary, is that a month after I upgraded Store Capital, one of the biggest institutional investors on the planet wanted in for a piece of the action. That's right, Berkshire Hathaway wrote a $377 million-dollar check to become a 9.8% owner in Store.

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Source: Yahoo Finance

That not good enough?

Then let's go back to February 2018 when I decided to write an article defending a short thesis for Realty Income (O). In response to an article suggesting "Realty Income is now declining organically and faces 30%-45% downside risk" I fired back stating,

"…my BUY recommendation is stronger than ever, and I am taking advantage of the noise to accumulate more shares. Spruce Point's article, although not well thought out, did provide a valuable service, and I can assure you that you will never see my shorting a BLUE-CHIP REIT like Realty Income."

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Source: Yahoo Finance

By now, it should be quite clear that my knowledge and experience as a net lease investor and developer has paid back in spades. I not only know how the product is built, but also how it can generate massive value, if and only of you understand the concept of the margin of safety. As a REIT analyst, it's my job to mine for gems that can be polished into jewels for my family and extended family (members of my marketplace community).

Today I am going to provide you with the details of another extraordinary opportunity that is ready for the center stage. Like the other examples cited (above), this particular REIT has all of the potential for enhanced price appreciation and we are adding it to our highly vetted collection of Strong Buys.

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Photo Source

Spirit Realty Is Not So Spooky Anymore

Some of you may recall an article that I wrote called "Spirit Spooks Me: No Tricks, No Treats, Just Another High Risk REIT". That was in 2012, almost seven years ago, and this was my very first article on the company.

Over the years, I have flip-flopped on Spirit Realty (SRC), mostly neutral during this time, as I was keeping my distance from the previous management team. My latest article (in December 2018) was positive, but I opted to stick with a HOLD as I was "wresting with conflicting management arrangements".

Also, I knew I couldn't ride all of the net lease horses, so I stuck with EPRT, that has proven to be a solid decision, as viewed below:

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Source: Yahoo Finance

Nonetheless, Spirit is now free of its overhang as the company has announced that it has broken free from the "legacy spirits" (pun intended), by severing the external management agreement with Spirit MTA REIT (SMTA) so the company can be sold to Hospitality Property Trust (HPT).

Specifically, the Master Trust 2014 and three assets presently owned by Spirit are being sold to Hospitality Properties Trust for $2.4 billion in total cash consideration, subject to certain adjustments. The closing is expected to occur in the third quarter of 2019.

In a press release, Spirit's CEO (and Chairman of SMTA and President) said,

"As the external manager, Spirit has worked to maximize the value to shareholders by prudently managing the Company's assets, protecting the Company from problem tenants and assisting in their accelerated strategic alternatives process. Today's announcement represents the most critical step in the full wind-down of SMTA and looking ahead, Spirit will continue to partner with SMTA's Board of Trustees to liquidate the few remaining assets and seek maximum recovery on the Shopko B-1 Term Loan."

At closing, Spirit is to receive an asset management termination fee of approximately $48 million and $150 million for the redemption of the company's preferred equity ownership in SMTA. Spirit will also receive approximately $28 million in net asset sale proceeds after approximately $27 million in related party note repayment. The company also gets approximately $34 million for the repayment of Master Trust 2014 notes held by Spirit.

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Source: SRC Investor Presentation

The shaded green box above illustrates the $286 million in cash that Spirit will receive at closing and the impact to AFFO (top left box above) highlights the difference between the Q1-19 AFFO reported (of $295.3 million) and the adjusted illustrative (proposed) annualized AFFO after the SMTA sell is closed (of $259.2 million). This difference equates to a quarterly AFFO impact of $.10 per share (or $.40/sh annually).

Spirit Has Ample Liquidity

In January Spirit increased its unsecured credit facility to $1.62 billion resolving the company's near-term debt maturities while maintaining flexibility for long-term debt issuances. In May the company received a ratings upgrade from S&P to BBB/stable. Here's how Spirit's credit metrics have improved from Q1-18 to Q1-19:

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Source: SRC Investor Presentation

Sprit has made substantial balance sheet improvements and raised a significant amount of equity year-to-date. As depicted in the chart below, assuming the full physical settlement of all the company's forward equity sale agreements currently outstanding, Spirit has over a billion in cash and revolver borrowing capacity, with the closing of the SMTA transaction expected to add another $268 million to their coffers - for total liquidity of approximately $1.4 billion.

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Source: SRC Investor Presentation

With so much cash on hand, Spirit will soon be on the offensive to grow without the SMTA overhang. A few weeks ago, I provided a WACC (weighted average cost of capital) model for Spirit and all the net lease REIT peers, here are the results:

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As you can see (above), we modeled Spirit's WACC to be approximately 5.2% but after the latest news, I decided to update the model as follows:

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Source: iREIT

Keep in mind, this model does not include the war chest of cash that Spirit will soon have to deploy and this will in turn provide the company with enhanced earnings as the cash is deployed in Q3-19 and Q4-19. So when we think about the run rate for Spirit, it's important to forecast the company's 2020 earnings growth.

Show Me The Money

As viewed above (last chart) we believe the Spirit's run rate AFFO per share (post SMTA) is $.74 per share and the full year run rate is $2.96 per share. But keep in mind, Spirit will have $1.4 billion of growth capital that should allow the company to generate substantial growth and simultaneously lower its cost of capital (multiple expansion).

Spirit has a secret sauce that consist of proprietary tools that provide an analytical guide to aid in acquisition and disposition decisions.

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Source: SRC Investor Presentation

Last week when I was attending REITweek, Spirit's management team showed me some of the company's proprietary tools that are used to rank individual properties.

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Source: SRC Investor Presentation

Spirit's "new" management team should be credited for this suite of risk management tools and it's very clear that these senior-level execs are focused on building a net lease REIT differentiated technology investments.

In terms of acquisitions, Spirit appears to be somewhat of a hybrid between Realty Income (O) and Store Capital (STOR):

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Source: SRC Investor Presentation

The above chart is telling, because it illustrated the dispersion of credit across the Spirit customer base. For obvious reasons, you can see (on the left) that the investment grade tenants (like Walgreens) don't report unit-level sales (think Realty Income) and the non-investment grade tenants are master-leased (like Store).

This provides evidence that a merger with Realty Income would not make much sense since Realty Income doesn't invest (or need to invest) in non-investment grade tenants and alternatively, it would not make sense for Spirit to combine with Store because of the investment grade-rated tenants within the Spirit portfolio.

Pound-for-pound, Essential Realty Properties appears to be the closest peer to Spirit (post SMTA). Speaking of EPRT…

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As you can see, EPRT has seen considerable multiple expansion, but not Spirit…

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What about Spirit's dividend yield?

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What about the payout ratio?

It appears that Spirit's AFFO payout ratio (pro-forma, post SMTA) is 82% - 83% (our 2019 modeled AFFO per share is $2.96 and dividend is $2.50 per share). The company's long-term payout ratio is 80% and that seems reasonable since Spirit has no office exposure (higher cap-ex and leasing fees).

Spirit has assumed modest growth in 2019 (with recycling) and the market has not factored in the fact that SMTA is being sold to HPT (at a 7.1% cap rate). What a great deal for Spirit investors and what a stinky deal for HPT (yes, I will be writing on that deal soon).

So, EPRT trades at 20x P/AFFO and STOR trades at 18.2x P/AFFO, while Spirit trades at 12.2x. For fun, let's assume Spirit's can move in-line with its direct peers and you can see that Spirit is far from spooky…A screenshot of a cell phoneDescription automatically generated

Source: FAST Graphs

In summary: We are upgrading Spirit to a strong buy and we are reiterating our strong sell for Hospitality Property Trust. I know you've heard me saying before that, "one man's trash is another man's treasure", but that certainly doesn't apply to SMTA. We're happy to see Spirit's "trash" portfolio disassociated from SMTA, but HPT will soon inherit the spooky portfolio. We believe that Spirit is now poised for profit.

Disclosure: I am/we are long O, STOR, EPRT, WPC. 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: 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 its only purposes are to assist with research while providing a forum for second-level thinking.