W. P. Carey: CPA:18 Merger Strengthens Bull Thesis

Summary

• The CPA:18 merger is the most impactful announcement in the first quarter for W. P. Carey and paves the way for future growth.
• The total merger is valued at around a sizable $2.7 billion.
• However, the balance sheet and capital structure remain conservative and well-positioned.
• I view it as a very positive move both in the short and long term.
• It substantially simplifies the business model and enables a sharper focus on the core strength.
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Thesis

W. P. Carey (NYSE:WPC) reported strong earnings results for Q1 2022 on April 29, 2022. Total revenue came in at $348.44M, representing an 11.98% increase YoY and beat expectations by $7.48M. Total AFFO came in at $258.8 million or $1.35 per diluted share. Notably, thanks to its premier real estate portfolio and high-quality tenants, it maintained a high occupancy rate of 98.5%, quite consistent with its historical averages, despite the COVID-19 pandemic and the global financial turmoil. Furthermore, the overall collection rate exceeded 99.7% for Q1 rent due.

Looking forward, there are some uncertainties on the horizon such as raising interest rates, inflation, and the geopolitical situation in Europe. However, I see WPC well positioned to navigate through these challenges and maintain my bull thesis. As you will see next:

• In terms of raising interest rates, WPC was able to lock in a low borrowing rate for a good portion of its debt. At the same time, the debt-to-equity ratio is near a bottom in a decade, and the lower cost of equity can offset (or more than offset) much of the impact generated by the higher cost of debt.
• In terms of inflation, 99% of its leases have rent increases built into the leasing contracts, including approximately 60% linked to CPI.
• Finally, the merger of CPA:18, the most significant announcement in Q1 2022 earnings in my view, paves the way for future growth, as detailed immediately below.

WPC 2022 Q1 Earnings Report

CPA:18 merger

As CEO Jason Fox commented below (abridged and emphases added by me), the CPA:18 was the most impactful event of the first quarter. I view it as a very positive move both in the short term and long term. it substantially simplifies the WPC's business going forward so it can better focus on its strength.

Our expectations on full year deal volume are, of course, before the impact of our proposed $2.7 billion acquisition of CPA 18, which is expected to add about $2 billion of assets after approximately $700 million of anticipated dispositions. Our announcement on CPA-18 was, in many ways, the most significant event of the first quarter, providing an excellent opportunity to add high-quality assets we know very well that are well aligned with our existing portfolio with minimal balance sheet impacts as well as essentially concluding our exit from investment management. As we said at the time of our announcement, we expect it to be immediately accretive to our real estate AFFO by around 2%, largely offsetting the earnings we will lose from no longer managing CPA-18 with attractive embedded upside through its self-storage portfolio.

I share the CEO's view and see several positives here. The merger is immediately accretive, its high-quality assets enjoy excellent synergies with WPC's core business, and it significantly simplifies WPC's business model going forward.

The total price tag for the merger came in around $2.7 billion. The total cost included the debt assumed, the 0.0978 WPC received by each CPA:18 share, and also the $3.00 cash for each share held. It is a sizable transaction (to put things under perspective, WPC's total market cap is "only" about $15 billion). However, investors do not have to worry about financial impact too much, because the merger has minimal impacts on WPC's balance sheet, as its CEO commented above. And as you will see next, the CEO's comments are corroborated by sound data and facts.

WPC 2022 Q1 Earnings Report

WPC and rising cap rates

Firstly, the CAP:18 merger did not increase the debt burden. Its current net debt stands at $6.77 billion. Compared to its debt level of $6.79B a year ago, it's actually a bit lower. Secondly, its borrowing costs will keep increasing if the pace of the interest rate hike we saw in the past few quarters continues. However, WPC was able to lock in a low borrowing rate for a good portion of its debt. Its current average borrowing rate is only 2.5% and its average maturity is 5.2 years as CFO Toni Sanzone commented below (the emphases were added by me)

At the end of the first quarter, debt outstanding had a weighted average interest rate of 2.5% and a weighted average maturity of 5.2 years. Our cash interest coverage ratio increased from 6 to 6.4x over the first quarter and remains among the strongest in the net lease peer group. We ended the first quarter with debt-to-gross assets at 39.7%, and net debt to EBITDA at 5.5x, both at the low end of our target ranges.

Furthermore, as the CFO also commented, WPC is currently very conservatively leveraged. As you can see from the following chart, in terms of debt-to-equity ratio, its leverage is actually near the bottom in a decade. Its debt-to-equity ratio has fluctuated between a bottom of 0.32 and a peak around 0.76 in the past decade. And the average is about 0.57. Currently, its debt-to-equity ratio is about 0.45, not only substantially below the historical average but also almost at the lowest level in a decade. So, in a nutshell, its current capital structure consists mainly of equity (55%) and to a lesser degree debt (45%). And a good portion of the debt is locked in at a low fixed rate for the next few years.

YCharts

Especially thanks to its high stock price recently, the benefits from the lower cost of equity probably more than offset the higher borrowing rates of debt. All told the current lower cost of equity will be more impactful than the weighted average cost of capital ("WACC") as you can see from the following chart. The borrowing cost certainly depends on interest rates. But thanks to the above factors mentioned (conservative leverage, well-laddered debt, fixed rates on a good portion of its debt, lower equity cost, et al), its interest expenses have not demonstrated a strong correlation with interest rates at all. As you can see from the chart, in the long term, its total interest expense actually fluctuates from the negative to the positive. And currently, the correlation is actually a negative correlation of -0.36.

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Final thoughts and other risks

I see the CPA:18 merger generating positive and long-lasting impacts, and therefore strengthening my bull thesis on WPC. The total merger is valued at around a sizable $2.7 billion. However, the balance sheet and capital structure remain conservative and well-positioned. Its debt-to-equity ratio is currently 0.45, close to the lowest level in a decade. The benefits from the lower cost of equity probably more than offset the higher borrowing rates of debt. Thanks to these offsetting factors, its interest expenses show no clear correlation against treasury rates, and currently actually show a negative correlation of -0.36.

Valuation is close to fair, maybe a bit on the overvaluation side. In terms of dividend yields, historical average is around 5.6% and its current yield is around 4.95%, representing about a 12% overvaluation. Such a small premium is nothing out of the extraordinary, especially considering the positive fundamentals and financial strength.

Finally, risks. The biggest risk I can see is the conflict in Ukraine and geopolitical uncertainties ongoing within NATO countries in general. From a narrower view, WPC has no properties in Ukraine or Russia. However, from a broader view, 35% of WPC's real estate assets are located in Europe (63% in the U.S. and the remaining 2% in other countries such as Canada, Mexico, and Japan). Therefore, an escalation of geopolitical tensions can negatively impact potential tenants and transaction revenues for WPC.

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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within 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.