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A Bargain You Won't Find In Your Local STORE

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About: STORE Capital Corporation (STOR)
by: Econ Alerts
Econ Alerts
Newsletter provider, research analyst, currencies, macro
Summary

STORE's current share price is around $40.39 and is trading at a discount to my fair value estimate.

The consensus estimate is for STORE's revenue to grow by 22.6% in 2019.

STORE's revenue and earnings growth in the last 5 years has been superior to its competitors, however, shares are still trading below the intrinsic value estimate calculated using conservative assumptions.

Investment thesis

STORE Capital (STOR), a holding of Warren Buffett, is structured as a real estate investment trust (REIT), ensuring the company distributes more than 90% of its income to investors. The stellar financial performance has lifted the shares 38% higher in the last 12 months.

Source: Eikon

At the current market price of around $40.39, shares yield 3.47% and are trading at a discount to my fair value estimate. There are growth opportunities for the company and the management is steering the company in the right direction by carefully vetting each investment opportunity in the real estate space. STORE Capital will likely generate alpha returns to investors in the long term.

Company overview and business strategy

The business model of STORE Capital is to acquire and manage a portfolio of single-tenant operational real estate properties with a view of securing net-lease contract terms with its tenants. As per the latest regulatory filings, STORE operates more than 2,350 properties and has a presence in 50 states, which confirms the sheer scale of the company.

The geographic footprint of STORE Capital

Source: Third-quarter investor presentation

One of the primary business strategies of the company is to stay relevant and generate positive results even if an economic downturn occurs. With this view, STORE Capital focuses on onboarding tenants representing the services sector, as an economic recession would hit the industrial and manufacturing sectors harder than it would hit the services sector. The management has been successful in achieving this objective in the last decade or so. For instance, the services sector dominates the portfolio of the company by accounting for 49% of all properties held and managed. In contrast, the manufacturing sector, the retail sector, and restaurants account for 17%, 19%, and 16%, respectively.

The most unique aspect of the company's business model is the emphasis on acquiring and managing profit-center real estate assets, which provides an added reason for tenants to honor their rental payments in a timely manner as these profit-centers generate the bulk of their revenue and earnings. In the third-quarter earnings conference call, the management went on to highlight that this approach has already resulted in tenants prioritizing rental payments over their other commitments.

STORE Capital primarily targets the U.S. Middle Market, but the company management believes in renting their properties to top-quality tenants. The majority of tenants earn upward of $50 million in revenue and the management believes earnings higher than that in revenue should be sufficient to make timely rental payments.

Source: Third-quarter investor presentation

Distributing wealth to shareholders has always been a strategic priority of the company, which doesn't come as a surprise considering it's a REIT. However, what stands out is the balancing between distributing cash to investors and retaining a sufficient amount to support growing operations.

Industry outlook

The economic growth of the U.S. plays a major role in determining the success of REITs and other real estate companies. Since the financial crisis in 2008, the U.S. economy has continued to grow and received a boost from the Tax Cuts & Jobs Act passed in December 2017. The World Bank now projects global economic growth to a slowdown in the next 5 years, including the American economy. However, at the same time, the World Bank and the International Monetary Fund both expect the American economy to grow at low-single digits through 2021.

According to data from the Federal Reserve, GDP growth will still be positive in the next couple of years.

Source: The Federal Reserve

Even though growth will be sluggish, REITs with strong balance sheets, high-quality investment portfolios, and growth prospects, will likely grow in the next few years.

Even though economic growth is not expected to be spectacular in the next few years, the unemployment level in the U.S. is still near record lows and the disposable income level is rising. Both these factors, in combination with the declining rates environment, provide a reason to believe that the real estate sector will continue to perform in line with expectations.

The unemployment rate in the U.S.

Source: Eikon

The declining interest rates might also be a positive contributor to the growth of this industry in the future.

The rate cuts this year were classified as mid-cycle adjustments, but many economists believe that this could well mark the beginning of the next rate-cutting cycle as well. In any case, the slowing down US economic growth will prove to be a reason for the Fed to consider keeping rates low in the next 5 years as well, in order to provide a boost to the economy.

Fed funds rate

Source: Eikon

Overall, despite the expected headwinds, the real estate sector can be expected to provide growth opportunities to the right companies.

Financial performance

STORE Capital is one of the fastest-growing companies in Buffett's portfolio and reported double-digit topline growth in each quarter over the last couple of years.

Source: Company filings

This continued growth is a result of the favorable macro-economic conditions, including the higher-than-expected economic growth in the U.S. However, the long-term strategy of STORE Capital to improve the quality of their real estate portfolio is also one of the main reasons behind this growth. For example, according to the second-quarter 10-Q filing, its tenants have grown their revenue at an average of 15% for the 12 months ended on June 30. This highlights that the majority of STORE Capital's tenants are experiencing revenue growth, which eventually indicates the presence of a good business model. In selecting its tenants, the company management looks for businesses that can withstand economic downturns and generate sufficient earnings to service rental payments.

Occupancy levels have consistently been over 99% in the last 6 quarters, which is another indication of both the quality of the property portfolio and the management.

The top 10 tenants of STORE Capital accounted for only 18% of the company's revenue in the third quarter, which confirms the absence of a high concentration on the top customers. This is a good sign for investors as a higher concentration would have put the company at risk of a possible failure of a company or two.

Maintaining a healthy balance sheet has always been a strategic priority of the company. Free cash flow and property sales proceeds are the primary sources of cash the company uses to honor its debt repayment obligations. As the below graph indicates, the majority of debt maturities occur beyond 2023, which significantly reduces the refinancing risk in the short term.

Source: Third-quarter investor presentation

According to data from third-quarter filings, more than 75% of the company's contracts are of investment-grade quality, which is a sign of the very high quality of its investments.

Source: Third-quarter investor presentation

There are no balance sheet demons and the company is growing its revenue supported by the high-quality property portfolio.

Outlook

As laid out in the third-quarter earnings conference call, the management has plans to grow the company both internally and externally. As per their estimates, adjusted funds from operations (AFFO) will grow at a rate higher than 5% in the future, resulting from favorable lease negotiations that lead to rental hikes and growth coming from cash reinvestments.

Source: Third-quarter investor presentation

External growth, on the other hand, will come from planned property acquisitions. At the end of the third quarter, the company had a pipeline worth $12.8 billion. STORE Capital had added new deals worth $3.2 billion in the quarter. As expected, these pipeline properties are spread across a variety of sectors and industries.

Source: Third-quarter investor presentation

With the closure of deals representing the pipeline, the company will be adding new revenue streams constantly in the next 5 years. These additions will likely help STORE Capital maintain its attractive growth rates and will likely lead to a higher distribution to shareholders as well.

The company will have ample market opportunities in the future as well. According to the latest data from Pitchbook, the U.S. Middle Market has over 200,000 companies. This large pool of companies is home to some of the best-performing companies in the country, and STORE Capital will likely continue to come across investment opportunities that fit into the selection criteria followed at the company.

Dividend safety analysis

The robust financial performance in the last 5 years has provided a platform for STORE Capital to increase its dividend payments in each year since 2015. Along with the capital appreciation return, these dividend hikes have provided a boost to the total return of investors.

Source: Seeking Alpha

As a dividend investor, the safety of dividends matters as much as growth does. STORE Capital has been covering its dividend payments with AFFO, and at the same time, growth has been achieved by carefully investing the remaining cash flow. This is an indication of the management striking a balance between distributing wealth to shareholders and securing sustainable growth in the long term.

Source: Company filings

The growth prospects for the company and the strength of the balance sheet ensure the safety of dividends.

Valuation

A two-stage dividend discount model was used to derive the intrinsic value of STORE Capital, as distributing cash to shareholders is a primary use of the company's earnings.

The consensus estimate is for revenue to grow by 22.6% in 2019. The below table provides a detailed projection for revenue.

Fiscal year

Revenue estimate (millions)

The implied year-over-year growth rate

2019

$660.07

22.06%

2020

$746.97

13.17%

2021

$837.19

12.08%

2022

$955.45

14.13%

2023

$1,006

11.32%

Source: Refinitiv Eikon.

This projected revenue growth will result in an increase in funds from operations as well, which is a crucial estimate in determining dividend growth for the next five years.

Fiscal year

Funds from operations per share estimate

2019

$1.90

2020

$2.03

2021

$2.16

2022

$2.33

2023

$2.46

Source: Consensus estimates and the author's projections.

Below are some of the other major assumptions used in the model.

  • A target funds from operations payout ratio of 70-75%. The management guided for a target payout ratio of 70% in the third quarter.

  • A perpetual growth rate of 2.5%.

  • Cost of Capital estimate of 7%.

Using these inputs, the intrinsic value of STORE Capital comes to $41.75 per share. This represents an upside of 3% from the current market price. Many investors would, in fact, consider that shares are trading at its fair value due to the lack of a healthy margin of safety. However, dividend investors should still find STOR trading at an attractive price, considering the yield of near 3.5% and the growth prospects that were discussed in an earlier segment.

STORE Capital stands out from a peer comparison perspective as well. For instance, the compounded annual growth rate (CAGR) of revenue of STORE tops that of its peers. The favorable industry outlook has certainly helped REITs in this period and STORE Capital has thrived with such supportive macro-economic developments.

Source: YCharts

However, even though STORE Capital has grown at a higher rate than its peers, the enterprise value-to-EBITDA ratio is still below the peer average of 19.5. This is also an indication of possible mispricing.

Enterprise value-to-EBITDA ratio

Source: Eikon

Conclusion

STORE Capital is a REIT that is continuing to exceed the expectations of investors and analysts consistently. Revenue and earnings growth in the last 5 years has been superior to its peers, but shares are still trading below the intrinsic value estimate calculated using conservative assumptions. The dividend yield is close to 3.5% and distributions are safe from a cash flow perspective. Dividend investors should find STOR an attractive investment, especially considering the growth opportunities the company is pursuing, the success of which would ensure the safety of dividends for the next 5 years as well.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in STOR over the next 72 hours. 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.