Shorting Store Capital Is Dangerous: 16 Reasons To Go Back To The Woodshed

Oct. 02, 2019 7:00 AM ETSTORE Capital Corporation (STOR)67 Comments

Summary

  • Last week there was a very bearish article on Store Capital (the author is short STOR).
  • I'm providing readers with my bullish sentiment - it's time to set the record straight.
  • Of course, this does mean it's time to go back to the woodshed. Again.
  • This idea was discussed in more depth with members of my private investing community, iREIT on Alpha. Get started today »

Today, I decided to debunk some bearish opinions on Store Capital (NYSE:STOR) that I recently found. Published by Authentic Alpha, the article is called “STORE Capital: a Wasting Asset,” and it doesn’t hold back.

My goal with this rebuttal is to validate this net lease REIT’s high-quality fundamentals – which are well worth talking about in a much more positive light.

Store Capital, for those of you who don’t know, is a leader in acquiring, investing and managing single-tenant buildings. Spread throughout the entire U.S. in middle-market locations, it has well over 2,000 property locations.

And it’s not sick of growing yet.

Hopefully, after reading my article, you’ll have a better understanding of why I stand by STOR. There’s truly a lot to like here.

But even if that weren’t true, I’d still need to point this out: That shorting a REIT is a dangerous strategy. It’s certainly not something I would ever encourage.

With that said, let’s get right to the misinformation about this real estate investment trust, and the facts that blow them out of the woodshed.

Photo Source

Our First Round of Facts

Myth #1: “STOR tends to (own) property in remote locations with troubling underlying credit. The company does not disclose the addresses.”

Fact: There are two assumptions here, starting with the idea that middle-market companies are all based in remote locations. But that’s just not so. Few of STOR’s locations are what could reasonably be called “remote.”

It’s true that some are in small towns. Yet people do live and eat and work, raise children, care for their pets, and open up businesses there, nonetheless.

The second assumption is that middle-market companies have troubled underlying credits. Yet STOR’s median tenant has revenue close to $60 million. And the weighted average dollar goes to tenants having revenue north of $800 million.

STOR even disclosed its tenant credit histograms – something that only one other net lease company that I know of (EPRT) has done.

Myth #2: “Aggressive growth is masking very weak credit performance.”

Fact: Again, STOR actually shows comparative tenant and STOR Score histograms in its quarterly presentations. No one else does that. For many quarters, the absolute number of vacant and non-paying assets has remained in single digits.

And that’s been despite a larger balance sheet. Occupancy today is 99.7%, and its lowest quarterly rate has been 99.2%.

Myth #3: “At ~$38 per share, STOR trades at an ~80% premium to my NAV (net asset value) estimate. PT (price target): $19 per share, ~50% lower than the current share price.”

Fact: STOR trades at a 5.6% cap rate. The company has shown it can originate investments at current cash yields of close to 8%, and then sell assets for prices closer to 7%.

To suggest that STOR’s NAV should be 8% is to suggest that it’s destroying value with every investment.

Another Round of Myths About STOR

Myth #4: STOR “originates single-tenant sale leaseback transactions with a focus on middle-market companies. Since its 2014 IPO, STOR has grown its asset base at a blistering pace (28% CAGR [compound annual growth rate]).”

Fact: While STOR's compound growth rate is high, you have to keep a few things in mind. For one, it was over 40% in 2015. And the net acquisitions target suggests a far lower 14% growth rate in 2019.

Myth #5: “Based on reported ~8% sale leaseback origination yields and the company’s attractive cost of debt and equity, STOR should have delivered mid-teens growth in AFFO (adjusted funds from operations) per share (AFFOPS). The actual growth from 2016-2018 was only half that rate. Where did the cash flow go?”

Fact: As you’ll see below, the suggestion is that STOR is growing its balance sheet at a constant 20% or higher and always trading at a 19X multiple with a 3.5% cost of borrowings.

If that was true, it could have grown at double digits. Instead, there's the implication that STOR isn't being as honest and upfront as it should be, a notion that isn't adding up.

The Misinformation Drags On

Myth #6: “A quarterly analysis of annualized base rent (ABR) allows investors to bridge results. My analysis identifies a large ‘hole in the bucket’ ranging from 200 to 300 basis points (bps) of ABR per year. I believe the company is restructuring leases and cutting rents significantly on a regular basis. If true, this has not been disclosed to the public.”

Fact: This is not so. At all.

In fact, STOR does a walk on internal growth in all of its quarterly presentations. It’s the only company I know of to do this.

Besides, even if STOR was to lose 200 bps of rent per year, its yield of 8% would fall to 7.38% over five years. And the weighted yield of the STOR portfolio would fall to below 7.5%.

However, if you take revenue and divide it into average annual gross assets each year, you’ll get to numbers north of 8%.

There's noise here, since using half-year conventions is highly imprecise, and since 10% of the annual business STOR does each year is in the form of new construction, which can have different lease payment characteristics during the building phase. That’s just a quick back-of-the-envelope look at the numbers to say that Myth #6 is indeed Myth #6.

In short, it's plain wrong. Again.

Myth #7: “I believe persistently weak credit performance has been covered up by aggressive growth funded with an overpriced stock. The actual loss-adjusted yield on investment is significantly lower than what STOR advertises.

“Once investors understand the real economics of STOR’s business model, raising additional equity could prove challenging. Without a premium valuation to fuel acquisitions, the company would be a wasting asset as credit issues would hit cash flow without an offset. I believe AFFOPS would decline 5% per year.”

Fact: In reality, STOR has $130 million in annual free cash flow after dividends to reinvest. Then it has 1.8% annual rent bumps. Together that gets to about 3.7% unlevered internal growth, which are best-in-class numbers.

The company loses about 50 bps to non-performing assets, including any lease concessions. Then, on average, it gets about 10 bps of accretion from asset sales activity. And STOR is among the only net lease REITs that shows it can do this.

That gets to unlevered average historical internal growth of 3.3%, as shown on p. 39 of its latest investor presentation. Levered, meanwhile, the number is closer to 5%.

For STOR to have no revenue growth, non-performing assets would have to rise to be close to 8X historic averages. That’s a margin of safety.

For STOR to have AFFO from operations actually fall by 5% a year, the comparative non-performance rate would have to rise to somewhere around 12X historic reported averages.

It doesn't make sense.

The Truth About Net Lease Companies Like STORE

Myth #8: “The current share price is ~$38 and is trading at a ~80% premium to my $21 NAV estimate. Based on the market reaction to other net lease REITs facing concerns around credit quality, STOR could trade at a discount to liquidation value. Price target: $19/share, or roughly 10x AFFOPS.”

Fact: Net lease companies are effectively non-bank financial services: Companies that offer their customers a landlord solution as opposed to a banking solution for their real estate finance. As such, NAV is sort of like book value for a bank, and all well-run banks should trade north of their book value.

The net lease space has historically traded for north of NAV – one of the few REIT sectors that can say this. A 10X multiple would represent a roughly 10% discount to cost, which makes no sense.

If that were to happen to STOR, expect other companies to have their valuations crater.

By the way, you may recall that Ben Axler tried a similar short wager on Realty Income (O) back in February 2018. As he explained,

“… we have issued a "Strong Sell" opinion and a long-term price target of approximately $28-$35 per share, or approximately 30%-45% downside risk. Please review our disclaimer at the bottom of this email.”

To which I responded the next day as follows:

“Spruce Point has a target ‘of approximately $28-$35 per share, or approximately 30%-45% downside risk.’ This means that shares will have to go into the low $40s to clear some coin (for him). Conversely, I believe that Realty Income will generate 4%-6% AFFO/share growth in 2018... Clearly, we are on opposite sides of this trade.”

I then added:

“Bill Ackman learned his lesson in 2009. And perhaps Spruce Point will think of Realty Income when he listens to my favorite Doobie Brothers song. As I said, Michael McDonald was trying to recount a love-sick relationship – a fantasy of sorts… he was not living in reality. I’m pretty sure that’s what he meant when he sang, 'What a Fool Believes.’”

Source: Yahoo Finance

Missing the Mark

Myth #9: “Unlike many net lease peers that focus on investment grade credits, STOR has a direct origination platform, sourcing real estate from middle-market businesses. This allows STOR to acquire real estate at sector-leading yields from a large addressable market.

“Middle-market businesses are typically associated with higher risk and lower credit quality. STOR claims to mitigate credit risk with its lease form and diversification. We do not believe that this is effective.”

Fact: Based on what?

This is like the Bill Ackman example referenced above, where he was trying to short Realty Income because he misunderstood that the company owned the profit centers of middle-market companies – which made them far higher up on the capital stack in terms of priority.

STOR is creating investment-grade contracts by financing unrated companies and sitting at the top of their payment priority. It then enhances this structure with portfolio diversity.

As Nobel laureate Harry Markowitz once observed, if you have enough diversity and low correlation, you have the potential to shift risk to zero.

Myth #10: “STOR originates sale leasebacks at ~8.0% yields, considerably higher than industry peers… the company earns a marginal return on equity of ~12%.”

Fact: Look at the formula to see that this is false. Return on equity (ROE) adds the lease escalator – thereby using the Gordon constant growth formula – to compute investment ROE. But STOR doesn’t get the escalator now. It gets it later.

Without the lease escalator, the current ROE/AFFO yield on investment would fall closer to 8.25%.

These Numbers Are Wrong Too

Myth #11: “STOR should deliver substantial AFFOPS growth because they raise common stock at a ~5% cost of equity. This is one of the largest spreads in the industry. I estimate that 20% growth in the asset base should generate ~8% AFFOPS growth while maintaining the same debt-to-equity ratio…”

Fact: Sounds logical, right? Except that STOR’s balance sheet growth in 2019 will be closer to 14%. And its weighted investments will be less than that since you don’t get all the revenue during the year in which you raise the capital.Source: iREIT

Myth #12: “AFFO and AFFOPS typically do not grow proportionately. Newly-issued stock immediately lowers AFFOPS growth at the time of issuance because the same AFFO is divided by more shares. Thereafter, the AFFO generated by new investments produces enough AFFOPS growth to offset the impact of share issuance. The lower the cost of equity, the more growth.”

Fact: STOR’s target 2019 investments are $1.1 billion. Of this, about $210 million can be internally funded. So external growth is then around $890 million, or about 11.5% on a beginning balance sheet of $7.7 billion.

Essentially, this is double-counting by adding growth from reinvested cash to STOR’s overall investment number – which is then called external growth.

If you lower the external growth to 11%, you get to about 9% (or more) AFFO growth per share in year two. However, the assumptions involved in that are simplistic and ignore timing. Moreover, while STOR’s rents do bump 1.8% on average, about a third of them kick in every five years.

So there are lumps to this number. Plus, the bumps tend to have a consumer price index (CPI) component to them. This means if there's inflation below 1.5%, the company can lose some of the bumps.

Finally, there’s construction to take into account. That amounts to about 10% of volume, which can have an impact on investment yield during the construction phase.

Keep in mind: This analysis ignores defaults and lost rents, which otherwise is a big deal of in the model. Per slide 39 of STOR’s 2Q-19 presentation, the average amount lost is a net of about 40 bps, assuming recycled real estate gains are included.

Also, the short seller seems to assume:

  1. A borrowing cost of 3.5%

  2. That STOR is trading at a 19X AFFO multiple.

Yet remember that its historic average borrowing costs are closer to 4.5%, and how STOR did not trade at a 19X AFFO multiple until it hit a price record on Sept. 4, 2019.

As of the last Q2 earnings release, the price to AFFO was 17.1X. The lowest price/AFFO multiple was when the company reported Q1-17 earnings at 12.2X. And the average AFFO multiple since it went public has been 15.5X.

So if STOR were to have always had a price/AFFO multiple of 19X, and were to always have growth at over 20%, and were to always have had a 3.5% borrowing cost and similar operating costs as a percentage of revenues. Then it might have had double-digit growth every year.

Instead, we see numbers like these:Source: iREIT

Myth #13: “I believe the shortfall in growth stems from poor credit performance. Since 2016, the company has reported annualized base rent and acquisition/disposition activity on a quarterly basis. This allows investors to bridge ABR from one quarter to the next as follows:

“Starting ABR + Acquisition ABR – Disposition ABR + Contractual Rent Increases – PLUG = Ending ABR.”

Fact: These comments are especially troubling. Yet the company’s financial statements and numbers fully work out.

Not just that, but there's a clear lack of understanding displayed about constructing net lease models. There are many analysts who do know how to put them together, and their numbers triangulate around historic guidance.

Myth #14: “The company reports very high occupancy rates and claims to have credit loss consistent with the rest of the industry.”

Fact: No other REIT discloses credit loss to my knowledge.

This Isn’t Right

Myth #15: “Unlike most REITs, STOR does not disclose the actual address of its properties (a big red flag), by triangulating company disclosures with general web searches and property databases, I was able to get a sense of what STOR has acquired. STOR appears willing to buy property in tiny towns with questionable re-use.”

Fact: This is not a red flag. STOR doesn’t disclose because:

  • Direct originations are a strength.

  • It doesn’t want to open its tenant list to every competitor.

  • Most importantly, a list would tell you nothing about which properties are “good” vs. “bad.”

That last point is because “good” is a function of more than physical appearance or market size. As I’ve discussed many times in the past, STOR’s secret sauce is its unit-level reporting and lease structuring.

Therefore, cherry picking properties based on Googled images alone doesn't make sense. Nor does asking readers to add a “clustering illusion” bias. The implication is that, if the carefully selected stores he’s chosen look so “bad,” just imagine what else there is!

That case might look "good" on paper, but it falls apart in no time flat in actuality.

Myth #16: “I estimate the company’s NAV to be $21 per share by applying an 8% cap rate to cash NOI (net operating income). The stock trades at an unfathomable ~80% premium to NAV. STOR trades at 20x AFFOPS and fetches a paltry 3.7% dividend yield. Clearly the stock is priced for unfettered growth.”

Fact: Here, the article assumes that STOR actually loses money with every investment. Whereas the company’s sold tons of real estate at average annual cap rates in the 7% area.

For proof, I’ll once again point you back to the REIT’s presentation, this time page 38 specifically. Between 2016 and 2019, its average sale cap rate – inclusive of troubled assets – was 7.4%.

A 7% cap rate on STOR’s performing assets would be conservative for NAV. You could go lower too.

In short, 8% does not compute.

Back to the Woodshed: 4 Pillars of REIT Investing

Back in February 2018, just after the Realty Income short thesis was published, I explained the following:

“I recently commented in the above-referenced article that I was ‘going out to the woodshed now.’ And by that, I was simply suggesting that I was going out to the woodshed to get inspiration for my article in hopes that the author (and other bears) would recognize that it's almost impossible to make money on timing. (There are four pillars to the woodshed.)”

I included the quote below from Frank J. Williams:

"People suffered the agony of financial loss, and many had to start life over again because they would not take the trouble to learn the rules of the game they were playing.”

We maintain a hold on STOR based solely on valuation. We're waiting on improved margins of safety to purchase new shares. But we are otherwise perfectly content with the business model and the management team that's running it.

Of course, one of the primary reasons I remain bullish with regard to STOR is because the company has invariably had the lowest payout ratio, with the exception of the jump in Q3-17 (when Berkshire purchased shares that diluted shareholders by 9.8% and the payout ratio popped).

Since then, STOR has put their money to work and has grown and the payout ratio has returned to a record low level at the end of last quarter. With the recent 6.1% dividend hike, the payout ratio will rise a bit next quarter

(Note: EPR went south of 60% for a quarter, but it was when they had some lease termination fees that they ran through AFFO. That shows that doing that creates confusion. A word to the wise it to be very cautious in adding lease termination fees to AFFO.)Source: iREIT

I hope this article was helpful in clarifying a few points. And I’d strongly advise readers to be careful when shorting a REIT like Store Capital. It's extremely dangerous to short a REIT, especially a REIT that pays very stable and predictable dividends. Besides, STOR has been a gem for Berkshire Hathaway, delivering returns of 29% annualized since June 26, 2017, and returns of 34% annualized after I upgraded the company (May 17, 2017) to a Strong Buy.

Source: F.A.S.T. Graphs

Author's note: Brad Thomas is a Wall Street writer, which 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: written and distributed only to assist in research while providing a forum for second-level thinking.

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This article was written by

Brad Thomas profile picture
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Brad Thomas is the CEO of Wide Moat Research ("WMR"), a subscription-based publisher of financial information, serving over 6,000 investors around the world. WMR has a team of experienced multi-disciplined analysts covering all dividend categories, including REITs, MLPs, BDCs, and traditional C-Corps.

The WMR brands include: (1) The Intelligent REIT Investor (newsletter), (2) The Intelligent Dividend Investor (newsletter), (3) iREIT on Alpha (Seeking Alpha), and (4) The Dividend Kings (Seeking Alpha). Thomas is also the editor of The Forbes Real Estate Investor and the Property Chronicle North America.

Thomas has also been featured in Forbes Magazine, Kiplinger’s, US News & World Report, Money, NPR, Institutional Investor, GlobeStreet, CNN, Newsmax, and Fox. He is the #1 contributing analyst on Seeking Alpha in 2014, 2015, 2016, 2017, 2018, and 2019 (based on page views) and has over 102,000 followers (on Seeking Alpha). Thomas is also the author of The Intelligent REIT Investor Guide (Wiley). 

Thomas received a Bachelor of Science degree in Business/Economics from Presbyterian College and he is married with 5 wonderful kids. He has over 30 years of real estate investing experience and is one of the most prolific writers on Seeking Alpha (2,800+ articles since 2010). To learn more about Brad visit HERE.

Disclosure: I am/we are long STOR. 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.

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