- 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.
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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:
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:
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:
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.
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.
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.
25 Stocks I Like More Than PLD
PLD didn't make the cut - the Best of Breed portfolio features over 25 stocks rated strong buy or even conviction buy.
Some investors start by looking at valuation with a stock screener, and from these cheap companies try to find any that they can justify buying. I instead start with an assessment of quality, and only from the highest quality companies do I begin to search for value. My goal is to not only beat the market but to also do so with a high success rate.
This article was written by
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.
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