Prologis: Voicing My Concerns Regarding Capital Allocation (A Red Flag)

Summary

• PLD is a top-tier logistics REIT which has delivered strongly on growing cash flows.
• The company has tremendous opportunities for investments to meet booming demand.
• My gripe is that PLD seems averse to issuing equity at blistering valuations in spite of REIT peers being more than willing to aggressively issue equity at lower valuations.
• I don’t think PLD’s valuation is sustainable, and I am concerned that management doesn’t realize that shares are richly valued.
• Looking for a helping hand in the market? Members of Best Of Breed get exclusive ideas and guidance to navigate any climate. Get started today »

Prologis (NYSE:PLD) is a best-of-breed logistics REIT which, due to being the landlord of warehouse real estate, squarely benefits from the tailwinds of e-commerce. PLD has an incredible track record of growing cash flows and maintains an A- rated balance sheet. The strong track record has earned it a premium valuation, which begs the question: why is PLD choosing to primarily issue debt instead of stock to fund acquisitions and development? I explain how best-of-breed peers in other industries choose to issue stock when their stock prices are "high" - and PLD's stock is even higher than those levels. Due to valuation, I am neutral on shares.

King Of Logistics Real Estate

PLD is a logistics real estate powerhouse with 4,660 building spanning over four continents:

(2020 Q1 Supplemental)

Logistics real estate is in high demand; it benefits from tailwinds such as e-commerce and also in general is mission-critical for the supply chain:

(2020 March Presentation)

Because of the high demand for its properties, PLD is able to generate strong SS NOI growth in the 3-4% range on the backs of leasing spreads in the 20% range:

(2020 Q1 supplemental)

In addition to internally generated growth, PLD invests roughly $2.4 billion annually into developments at an estimated 6.3% NOI yield, which it believes will stabilize at 4.5% yield. PLD believes it can achieve 8-9% FFO growth through the aforementioned SS NOI growth and development activity, as well as realizing operational efficiencies and effect from leverage:

(2020 March Presentation)

There are a lot of good things to say about PLD - now I'll discuss an unusual gripe.

Questioning Capital Allocation

Put simply: PLD stock trades very richly. At recent prices, it trades around 26 times trailing core FFO of $3.31 and 24 times forward core FFO of $3.60 per share. With a valuation like that, you'd think that PLD would be aggressively tapping the equity markets to fund acquisition and development activity. Surprisingly, that's not what's happening. PLD raised approximately $800 million in debt in 2019 and raised an additional $800 million in the first quarter of 2020. PLD did not issue any equity. I would have expected PLD to instead fund a substantial portion if not all of that with stock. As I show just below, other logistics REITs are (correctly) aggressively issuing stock.

PLD has an A- credit rating with debt to adjusted EBITDA at 4.2 times. Due to its strong balance sheet, PLD takes pride from not having to issue stock since 2015:

(2020 March Presentation)

Sure, it may be tempting to take advantage of the low interest rate environment, but then you have to deal with debt refinance risk down the road (interest rates might be higher later). I'd argue that even more opportunistic than low interest rates would be to take advantage of high equity prices, as the stock does not have refinance risk. Further, issuing stock would boost its balance sheet flexibility, still leaving it the option to issue debt at low interest rates in the event that its stock is no longer trading at high valuations. It would make a lot of sense to issue stock right now, bringing debt to EBITDA as low as possible in the process, then rely on levering up the balance sheet if or when the stock trades lower.

Perhaps you might think that PLD wasn't clearly expensive at the 25-27 times core FFO it has traditionally traded at, due to its 8-9% FFO growth. We should first normalize FFO growth to only include internally generated growth, as otherwise we'd be double-counting the retained cash flows. I estimate PLD to have approximately 5-6% of internally generated growth from leasing spreads and operational efficiencies (depending on how confident you are that operational efficiency growth is sustainable). I note that logistics REIT peers have been issuing stock. Duke Realty (DRE) raised $250 million in debt and issued $270 million in stock in 2019. EastGroup (EGP) raised $100 million in debt and issued $285 million in stock in 2019. Other peers are doing the same - for whatever reason PLD isn't following suit.

It becomes even more clear when we look across the REIT sector. Let's compare with two REIT peers in Realty Income (O) and Federal Realty Trust (FRT).

For much of the past few years, O has traded at around 21 times FFO. O has internal growth of approximately 1-2% (annual lease escalators). What has O done with that valuation? It has been issuing stock as aggressively as it ever has - in 2019 it raised $1.4 billion from debt, but raised over $2 billion from stock.

FRT has frequently traded at around 22 times FFO over the past few years. FRT has internal growth of approximately 3-4% (lease escalators and leasing spreads). It has been a ready issuer of stock as well. In 2019, the REIT raised $88 million in debt, but raised $143 million in stock.

While it is true that PLD has slightly higher growth at 5% versus the 1% at O and 3% at FRT, but PLD's 26 times historical core FFO multiple was also significantly higher than the 21-22 times FFO multiples at O and FRT. Whereas O and FRT were aggressively issuing stock, PLD was not issuing any stock. There is a clear disconnect between the capital allocation policies of PLD versus O and FRT, in spite of all three investing at very similar NOI yields and having similar growth rates. PLD deserves significant praise for doing an excellent job, no doubt, but I am concerned that management may be overestimating the value of its stock. Investors commonly know that you want a management team which can take advantage of an undervalued stock by repurchasing shares - less commonly known but arguably more important is having a management team which can take advantage of an overvalued stock by issuing shares. In order to do the latter, you need a management team that can recognize when its stock is richly valued, which doesn't seem to be the case here at PLD. Just because PLD doesn't need to issue stock doesn't mean that it should be ramping up leverage while its stock trade so richly.

Conclusion

PLD is a top-tier operator in a booming industry. PLD is able to generate incredible leasing spreads in addition to having seemingly endless investment opportunities. I am however concerned that PLD has been avoiding issuing stock to fund its extensive investments - its shares trade more expensively than peers which are more than willing to issue stock at lower valuations. With an A- rated balance sheet and debt to EBITDA at 4 times, PLD isn't necessarily in any danger from a balance sheet perspective and doesn't have any urgency to deleverage. I think it makes a lot of sense to refinance any debt maturities with longer-dated debt at lower interest rates. That said, when it comes to funding investments by either taking advantage of low interest rates to issue debt or taking advantage of high stock valuations to issue equity, preference should be given to the latter - yet PLD is not issuing any stock at all. PLD's stock valuation appears to be propped up by its high 20% leasing spreads and low cap rate valuation on its properties. I don't view these two items to be sustainable in the long term - an eventual reversion to the mean would potentially reprice PLD's long-term 2-3% growth rate to an FFO multiple of 13-18 times. It would be a shame if PLD didn't take advantage of the current market euphoria of a 25 times FFO multiple before then.

Analyst’s Disclosure: I am/we are long FRT, O. 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.

DISCLAIMER: Julian Lin is not a Registered Investment Advisor or Financial Planner. While the information in his articles and his comments on SeekingAlpha.com or elsewhere may seem like financial advice, it is not, and it is provided for information purposes only. Do your own research or seek the advice of a qualified professional. You are responsible for your own investment decisions.

Comments

[ISTJ Investor]

Julian, interesting piece. You identify an opportunity that Hamid chooses to pass over. I say chooses because he’s obviously a bright and experienced guy, and as you note smaller peers (DRE) have provided examples. Curious as to your best guess / speculation as to why he hasn’t taken this option.

[Student - Value Investing]

Not sure I agree as the business does not need significant capex right now.

More of my thoughts here: medium.com/...

[Julian Lin]

Acquisitions are still high..

[yardbird99]

I think this article is a good argument for investing in PLD, even at current prices.

[Julian Lin]

Very funny

[user1416]

As a shareholder, I would rather see them issue debt as opposed to diluting shares or relying on their revolver. Until it ramps up debt/equity or leverage, I think it makes sense.

Looking at their most recent offerings, about half have early special redemption features.

So I guess I would rather see them issue debt at todays low rates with the option to call early over diluting shares and continually buying back.

[Julian Lin]

Normally, issuing debt would be better than diluting shareholders. But when your shares trade at 25 times FFO, the marginal dilution is more than compensated by declining leverage.

[user1416]

A lot of my large cap growth REITs are issuing debt right now. At current rates, they are going out to 2050. Part of this is obviously the need to shore up liquidity and have sufficient cash to outlast the pandemic and recession.

I just bought some of Equinix's bonds and they have a similar early redemption feature. I passed on AMT, CCI and PLD. I expect all will be calling debt early and shareholders won't be subject to earnings/FFO dilution. Had they issued shares, they would be saddled with buybacks, likely at higher prices. PLD already has a $1B buyback provision and I'm not sure why they haven't cancelled it but these guys are usually good allocators of capital.

[Julian Lin]

I don’t understand the buyback concept? Why would they be “saddled with buybacks?”

[Cyclenut]

Morgan Stanley up grades Reality O to overweight based on Q1 earnings that beat estimates

[Julian Lin]

Excellent!

[clcapital]

Let's get to the facts: They have been doing large acquisitions using equity instead, which is the same as issuing shares. The 2 most recent are (1) $13bn acquisition of Liberty Property (2) $4bn acquisition of Industrial Property Trust. Go look at the deal structure/term. Exactly what you want from management; using your own shares trading at higher multiples to acquire competitors at lower multiples = highly accretive. Basic shares outstanding has been growing ~26% in the past 5y to 630,580 (year-end 2019) from 499, 583 (year-end 2014). So I don't see at all PLD being averse to issuing equity.

[Julian Lin]

In this exact article we are commenting on, I showed the slide where PLD proudly declares that they aren't issuing equity.

Their shares outstanding is going up primairly due to stock-based compensation, and some token issuances of equity.

They have been primairly issuing debt because they want to do acquisitions in a "leverage neutral" manner - which I don't agree with, considering the lofty valuations seen across the sector.

[clcapital]

In that slide they are saying that they don't NEED to issue equity to fund organic growth (to mainly fund $2b of development and buying co-investment stakes). They are also saying they are not doing follow-ons. Doesn't mean that they are averse to it. When it comes to inorganic growth, they have been actively using their equity. Shares are also going up with their 2 recent all-stock deals (Liberty Property (not closed yet) and DCT were all stock deals). I'd prefer a company to use their expansive shares to acquire lower multiple players vs doing follow on offering or just issuing to fund organic growth when you already have enough capacity to fund them in the first place.

[clcapital]

Just to get back on the share-based comp. I did a quick calculation. They paid $364.3m in share-based comp (5y cumulative), divide that by the 5y avg share price of 57.86 = roughly ~6.3m shares issued (not perfect but you get a rough ballpark estimate). While in the last 5y, PLD issued ~130m shares (630.58m minus 499.58m). So clearly, share-based comp is not a big contributor of that increase in shares.

[Arimnestos]

Hamid may well be the smartest CEO in all of REITdom. The rates they achieve in the debt market may well be the lowest possible rates in all of REITdom. While I have wondered why they don't issue the occasional tranche of equity, I am not going to second guess Hamid. The man has made a $hit-ton of money for me and deserves a long leash. Very long PLD for, IDK, 20 years or so.

[Julian Lin]

Thanks for reading.
Their strong track record doesn't make the stock justified at 25-28 times FFO. That valuation is barely supported by their 5-7% FFO growth, and even that FFO growth won't last forever. Peer TRNO has recognized this and is aggressively issuing equity. It's a shame PLD isn't.

[Arimnestos]

I get your point, but again, I will put my faith in Hamid. I would also quibble with the idea that TRNO is a peer. PLD doesn't really have a peer.

[jhod58]

Julian what you are saying makes perfect sense. It’s interesting to postulate why they are refraining from doing this. I bought some PLD on the dip but was really keeping my eye on STAG. Thanks for the article!

[Julian Lin]

Thanks for reading!
It is especially curious considering that peers are doing the opposite- look at TRNO, which has reduced leverage by 33% (!!!!) over the past 4 years, due to being a willing seller of its equity. I should note that TRNO has actually grown its bottom line faster than PLD during that same process!

[jgrever621]

There is an old expression, 'if it works, don't fix it.' This seems to be the attitude for PLD, and clearly it is working.

While I sort of agree with the author, PLD is doing just fine, stockholders are happy, lenders are happy, what's to fix?

I am delighted (as a DGIer) to have dividends increase annually at a rather decent rate, and am NOT interested is any changes.

[Julian Lin]

While it certainly is "working," it could be better. Logistics REIT peers like TRNO have seen leverage decline precipitously whereas PLD hasn't, due to not wanting to issue equity.
It is very dangerous to have management teams who overestimate the value of equity - those investing in mall or office real estate know this far too well

[jhod58]

Especially when location definitley matters with industrial properties and cap rates. If PLD could be more aggressive without sacrificing their credit rating, why not?

[Julian Lin]

@jhod58
Ironically PLD could be even more aggressive if they used equity as a funding vehicle. It doesn't make sense to use the low interest rate from debt to justify paying a lower cap rate for a property. In 10 years, that debt may not be refinanced at a lower interest rate, but stock issuance never has to be refinanced.