Important Update On STORE Capital

Summary

• STORE Capital had a strong showing in 2021 and we expect the strong momentum to continue into 2022.
• STOR's net asset value is rising and its tenant health is improving.
• Will Volk's termination have a significant effect on STOR's performance going forward? Probably not.
• Looking for a portfolio of ideas like this one? Members of High Yield Investor get exclusive access to our model portfolio. Learn More »

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STORE Capital (NYSE:STOR) is one of our core holdings at High Yield Investor, so as we wade into the fifth month of 2022, we'd like to check up on STOR, examine its 2021 performance, and gauge its growth prospects for 2022.

The pandemic made for a difficult year in 2020, as rent collections from STOR's predominantly service-oriented tenants dropped considerably. From 2019 to 2020, AFFO per share dropped ~8%, from $1.99 in 2019 to $1.83 in 2020.

Net lease properties (STORE Capital)

But as the economy reopened last year, STOR enjoyed a strong rebound. Earnings growth was fueled by a rising rent collection rate as well as the collection of deferred rents and impressive acquisition volume totaling $1.5 billion. AFFO per share in 2021 of $2.05 rose 12% year-over-year, although it was only 3% higher than 2019's AFFO per share.

It's useful to remember, however, that COVID-19 was basically the kryptonite to STOR's Superman. It was STOR's unforeseeable Achilles' heel, given the large share (80%) of the tenant base in service-oriented industries. Now that the portfolio has largely recovered from this (hopefully!) once-in-a-century event, STOR can continue on its previous path of growth.

For 2022, driven by a planned acquisition volume of $1.1 billion to $1.3 billion, management has set the midpoint of 2022 AFFO per share guidance at $2.20, representing 7.3% earnings growth.

In this article, let's get a brief update on STOR, including some clarification on how its typical rent escalations work and finally some details on what exactly happened with the termination of former CEO Chris Volk.

STORE Capital's Net Asset Value Rising; Tenant Health Improving

In 2021, STOR invested $1.5 billion into acquisitions of new properties at an average cap rate of 7.5%. This average cap rate is lower than previous years' averages because of the broader compression of cap rates across almost the entire commercial real estate spectrum.

Cap rates are compressing (STORE Capital)

Despite compressing cap rates, though, STOR was still able to put money to work at an impressive investment spread over four points in the fourth quarter.

Notice above that STOR is consistently able to sell properties at a lower cap rate than its average acquisition cap rate. Of course, we do not know whether STOR is able to achieve gains on the sale of its vacant real estate, but the accretive capital recycling from occupied (or "performing") properties to acquisitions represent something unique about STOR.

Former CEO Chris Volk described STOR as "a contract creation company." In other words, the REIT plays the role of engaging in sale-leasebacks with otherwise bank-dependent businesses and creating high-yield leases for these assets. STOR can then turn around and immediately sell these properties in the secondary market for a lower cap rate than they acquired them.

The ability to generate these real estate-based contracts at a discount to their secondary market value is a competitive advantage for STOR, and it is one of the main reasons why we are so bullish on it.

Another competitive advantage is the REIT's growing list of tenant relationships. Around 45% of STOR's acquisitions in the fourth quarter were sourced from existing tenants, which is above the average of about one-third.

As we enter 2022, STOR boasts a huge pipeline of about $13 billion in real estate, of which STOR expects to acquire between $1.1 billion and $1.3 billion.

STORE Capital pipeline (STORE Capital)

Interestingly, management has given an acquisition cap rate guidance range of 7% to 7.2%, implying another big gap down in cap rates this year.

This implies that the value of its assets is rising and the risk of its tenants is decreasing. As Craig Barnett, EVP of Underwriting & Portfolio Management, stated on the Q4 2021 conference call:

"Our customers are experiencing robust top line growth and improved profitability. This is demonstrated by the improvement in our weighted average four-wall unit SEC for the portfolio from 3.9x pre-COVID to 4.6x for the most recent financials received."

Inflation & Rent Escalations

With inflation running hot, many investors are curious to know if STOR's lease terms have conditions allowing for higher rent escalations in accordance with high single-digit CPI rates.

STOR does not have CPI-based rent escalators - or, at least, not the kind that would raise rents with inflation. However, the REIT is still better positioned to handle inflation than most of its net lease peers.

On the Q4 conference call, CEO Fedewa gave three reasons why STOR may be less vulnerable to inflation than the market thinks:

1. "Triple net lease REITs do not generally incur property-related operating expenses."
2. "Our contractual rent escalations are meant to provide a natural hedge, allowing us to manage well in the current inflationary period."
3. "In addition, inflation has the potential to drive up the value of our real estate portfolio."

On the second point, what kind of rent escalations does STOR have?

The majority of the REIT's escalators rise at the lesser of 1.25x CPI or a fixed annual rate, which typically sits at around 1.8% to 1.9%. In other words, if the CPI is 1.2%, STOR's rent would reset higher by 1.5% (1.25 x 1.2%) rather than the higher fixed rate.

In the fourth quarter, with inflation running hot, the lesser number was the fixed rate of 1.9%. So, for as long as the current inflationary environment persists, STOR's same-store rent growth will probably remain 1.8% to 1.9%.

On a leveraged basis, however, this same-store rent growth results in contribution to AFFO per share growth over 2.5%.

STORE Capital path to superior internal growth (STORE Capital)

Together with reinvested free cash flows, STOR boasts perhaps the highest internal growth rate of all net lease REITs at over 5%.

Adding external growth to it, we expect STOR to grow at 6-8% per year, providing great inflation protection to its shareholders.

As such, STOR is better equipped for inflation than most other net lease REITs, like Realty Income (O) and Agree Realty (ADC), which focus on investment-grade tenants and feature average rent escalations of about 1% annually.

What Happened With Former CEO Chris Volk?

In late December, with no warning or explanation given to shareholders, STOR made an 8-K filing with the SEC saying that former CEO and current executive chairman of the board, Chris Volk, had been terminated without cause. Many investors found this concerning since STOR gave no commentary surrounding this sudden and unexpected termination.

STORE Capital's former CEO (STORE Capital)

Luckily, during the Q4 earnings conference call, an analyst asked for an explanation about this decision.

Here's Fedewa's somewhat vague response:

As it relates to Chris, once the management transition was complete and there was no longer really a need for the executive chair role, the Board felt that the Company would be best served by having new independent board members with new skill sets. So as you know, we appointed Tom Kelly to the Non-Executive Chairman of the Board role.

... And we've all worked a long time with Chris, and I guess I would like to say me personally for over 20 years. And we're excited about our next chapter, and we're really excited about his. And we wish him really and we're excited for all of us.

On its own, this answer seems a bit odd. Volk, the architect of this net lease business model, co-founder of the company, and widely admired public face of STOR, is no longer needed? And new independent board members with different skill sets, surely none of which include running the particular business model that STOR does, are an adequate replacement for Volk's brilliant mind?

Now, I do not mean to sell Fedewa short. After all, she is a co-architect of this business model, having worked with Volk for two decades. She seems just as brilliant, only less of a public apologist for STOR than Volk was.

STORE Capital's new CEO (STORE Capital)

But Volk's sudden and unceremonious ousting still felt odd for many, given Fedewa's long history of working with him.

Fortunately, the analyst pressed further on the issue, asking:

I guess it's just -- it seems as though if the goal was to not have an executive chairman upon the management or the C-suite transition. Why not just have Chris have a little bit -- I mean you guys obviously overlapped. Why have him go to the exec chair position for such a short period of time if again the angle is just to kind of get rid of that post after you have taken over the helm?

Here's how Fedewa responded (bolded print mine):

Well, as I mentioned, the management transition, [Sherry] was here. She's a 30-year veteran and CFO. It was important that we fill that position, and we're confident in that position being filled, and Chris was right alongside with us on that. So I think that was important. But once Sherry -- we found Sherry, and then that was sort of the key management transition position that we wanted to have in place, and that's pretty solid now.

So the team is solid and in place. And the position -- the executive chair position, it does come with an expense. And I think that the Board had -- it was a great vote of confidence for the Board that team was ready. And that for the shareholder, we could eliminate that position and terminate the contract and move forward, saving that expense for the shareholder.

In short, then, Fedewa is giving two reasons for Volk's termination by the board:

1. The company made a key hire at the executive level that made Volk's presence as executive chairman superfluous.
2. Volk was continuing to be paid handsomely to serve in his (now apparently superfluous) role of executive chairman, and the board determined that shareholders would benefit from this position being eliminated. The CFO mentioned at one point during the call that Volk's termination improved Q4 AFFO per share by about $0.02.

Now, will Volk's termination have a significant effect on STOR's performance going forward? Probably not. The situation could have been communicated better and accomplished without spooking investors. The hushed way in which news of the termination leaked (via an SEC form) gave a bad impression that caused at least some shareholders to sell.

During a CNBC TV segment, for example, portfolio manager Josh Brown said that he completely sold out of his position in STOR at least partially because of Volk's abrupt departure: "That was the guy for me. He was the founder, he was the architect of the business."

With that said, what's done is done. We cannot invest in the past. We can only invest for the future, and we do not believe anything has fundamentally changed about STOR's future prospects.

Bottom Line

STOR is firing on all cylinders, taking advantage of a favorable credit market to raise low-cost debt and of a huge acquisition pipeline to make selective investments. The REIT's 5%+ internal growth rate remains peer-leading, and its predominantly service-oriented and manufacturing tenants look poised to thrive in the post-pandemic economy.

Lastly, though parting ways with former CEO Chris Volk could have been handled better, we do not believe STOR's future growth prospects are changed by it. Fedewa has worked with Volk for decades and appears well-equipped to lead the company in his absence.

With a 5.4% dividend yield and 7.3% expected growth, investors can expect to earn a 13.1% total return in 2022, even without accounting for any multiple expansion. That's very compelling for a defensive, blue-chip net lease REIT and therefore, we expect to keep it as one of our largest holdings.

It has a clear path to generating above-average returns with below-average risk, and that's what active investing is all about.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of STOR; O; ADC either through stock ownership, options, or other derivatives. 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.