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A Critical Analysis Of O (NYSE: O) Shows It Is Now Declining Organically, With 30% To 45% Downside Risk

|About: Realty Income Corporation (O), Includes: AMZN, BRX, IYR, KIM, NFLX, RAD, SITC, WBA

O has long been a favorite of dividend seeking retail investors for its acquisitive growth and steadily increasing dividend. These results relied on growing its same store rent (SSR) profile.

O's reported SSR growth of +1.2% is misleading; it excludes vacancies. On a pro forma basis, we estimate SSR at -0.8% or 2% overstatement. The dividend coverage is also weakening.

Numerous examples of other REITs (DDR, Brixmore, Kimco) cutting SSR to negative growth has resulted in 40% - 50% share price declines.

O's management are all former bankers and real estateanalysts, so investors shouldn't be suprised by the optimisticly engineeredfinancial results. Beware, insiders own nothing and the audit committeeoverseeing management is very weak.

Analysts still see 18% upside in O, but with interest ratesrising, and organic growth now negative, it's not hard to justify its industryleading valuation premium contracting and 30-45% downside risk.

Report Entitled "O No, Growth Gone Negative"

Spruce Point Capital Management is pleased to announce it has released the contents of a unique research report on Realty Income Corp. (NYSE: O, "O Realty" or "the Company"). Spruce Point has conducted a critical business and financial review and believe the Realty Income is overstating its same store rent metrics to portray itself as a healthy, growing enterprise. Based on our industry normalized approach, which includes vacancies, we believe that Realty Income is in fact declining organically. We believe the overstatement of approximately 2%, makes the difference between the cosmetic appearance of a growing enterprise vs. a declining one.

As a result, based on our case study analysis of similar REITs that have swung to declining growth, and a detailed valuation analysis, we have issued a "Strong Sell" opinion and a long-term price target of approximately $28 - $35 per share, or approximately 30% to 45% downside risk. Please review our disclaimer at the bottom of this email.

Our detailed research report is available on our website. We also encourage all of our readers to follow us on Twitter @sprucepointcap for regular updates. Please review our disclaimer at the bottom of this email.

Executive Summary

The Allure of Rising Magic DividendsRealty Income (“O Realty” or “the Company”) promotes itself as “The Monthly Dividend Company®” and preaches “The Magic of Rising Dividends” – it even goes so far as to market itself differently to retail investors vs. sophisticated institutional investors. The Company is very dependent on issuing stock at inflated prices to fund its acquisitive growth strategy, keep its cost of capital low, and consistently raise its dividend. The model has worked well for years when times were good, but we believe this magic cycle is about to break down as investors reassess O Realty’s growth profile amidst  deteriorating tenant quality, and more volatile and discerning capital market backdrop

Deceptive Same Store Property Reporting: Our forensic accounting work indicates that the true underlying economic performance of O Realty’s properties, as measured by Same Store Rents (SSR) are declining vs. the company’s promotion that it is growing.  The Company disclosed its SSR growth rate of 1.2% in 2016.  Our industry normalized definition of same store property performance suggests that that SSR declined by 0.8% in that period – an astounding 2.0% overstatement.  Once investors come to grips with our irrefutable conclusion, we expect a major revaluation in O Realty’s share price. There are ample case studies to show 40%-50% share price declines when investors revalue a REITs declining performance. For example, Wall Street has penalized a few REITS (DDRBRXKIM) that own retail properties where the same store growth profile has swung from positive to negative growth. We believe that O Realty is the next REIT that is going to be penalized for a deteriorating growth profile by investors. 

Dispositions And Vacancies Are Rising And Likely Aiding Occupancy And SSR Metric Inflation: We believe that dispositions and vacancies are likely managed to cosmetically inflate occupancy and aid O Realty’s SSR metric.  We show dispositions on the rise as well as a larger percentage of property sales coming from vacancies.  These trends may indicate more competition from malls as well as the limited alternative use for many of O’s real estate properties.

Investors Should Be Concerned By Background of Management and Audit Committee Oversight By Board: We find that O Realty’s executive management team is comprised almost entirely of ex-investment bankers, trained in the art of financial engineering. It should, therefore, come as no surprise that O Realty could use financial magic to embellish its performance. We have little faith in the Company’s audit committee raising any objections or concerns about management’s practices. We find that the audit committee is comprised of a PGA golf professional, and former executives from Wells Fargo and KPMG, two of the most scandal-ridden financial and accounting organizations in recent history. Given all the factors we have noted, it makes sense that insider ownership trends are at all-time lows, and lowest amongst its REIT peers.

Tenant Quality Deteriorating As Retail Landscape Changes: We conducted a deep dive into the tenant quality and find that O Realty has outsized risk exposure to drug stores, grocery stores and movie theaters -- three retail subsectors facing disintermediation. Drug stores (O’s largest sector exposure) are consolidating their retail footprint (i.e. Walgreens (WBA) purchase of +2,000 Rite Aid (RAD) stores), while SSS performance at the store front is down. Even worse, headlines such as Amazon (AMZN) teaming up with Berkshire Hathaway (BRK.A) and JPMorgan (JPM) to disrupt the healthcare business present a now tangible long-term risk that the traditional drug delivery value chain through retail footprint could move increasing online. The Amazon risk extends also to the grocery store vertical given its recent acquisition of Whole Foods.  We believe that any retail transaction that is done repetitively and frequently (i.e. grocery and drug store) is ripe for online disruption, and therefore poses significant risk to the traditional brick and mortar chains and their related real estate profiles.  Lastly, movie theater trends (both box office sales and attendance) likely peaked in 2015, and theater chains are not expanding screens. Physical movie theater locations are at increasing risk of disruption as Hollywood and media companies (e.g. Netflix (NFLX), Amazon, Hulu) are spending money to produce original content for their own “at home” media streaming offerings, and new releases that skip the movie theater completely. 

Interest Rate Tightening Cycle Another Major Negative Backdrop For O Realty: We expect REITs such as O Realty to remain under pressure. Consensus expectations is that the 10 year treasury will surpass 3.0% by 1Q’19 and O Realty’s historical stock performance exhibits negative correlation with increases in interest rates. We expect O Realty to underperform the REIT sector (IYR) given our newly documented growth concerns and premium valuation enumerated below

Operating Metrics Have Deteriorated While O Realty’s Valuation Remains Sky High: O Realty has lured a dizzying array of analysts to relentlessly promote its story, and make it the most expensive triple net lease retail REIT by a wide margin. Analysts see an average of 18% upside to $59/share, yet seem to ignore glaring signs of weakness. Even Janet Yellen warned that commercial real estate prices are “quite high relative to rents.” O Realty has the lowest occupancy rate of 98.3%. If it had not sold 91 vacant properties since the beginning of 2016, the occupancy metric might be as low as 96.6%.  Furthermore, O Realty essentially has the lowest remaining lease term of 9.6 years amongst its peers and the highest amount of leases expirations (7.8%) versus their peers over the next two years. In that context, we created a dividend sustainability index where we incorporate average remaining lease duration in order to assess O Realty’s sustainable dividend paying ability vs. prior year periods.  This index now stands at its lowest level since the beginning of our data set in 2005.  Metrics like this can be an early warning sign that the underlying fundamentals are not as safe as they had been historically. We expect that once investors come to grips with the fact that O Realty’s true growth rate is negative, its multiple will re-rate in line with historical precedents, and its share price will decline by approximately 30% - 45% or $28 - $35 per share. 

Thank you very much for your continued interest in our investment research.


This research presentation expresses our research opinions. You should assume that as of the publication date of any presentation, report or letter, Spruce Point Capital Management LLC (possibly along with or through our members, partners, affiliates, employees, and/or consultants) along with our subscribers and clients has a short position in all stocks (and are long/short combinations of puts and calls on the stock) covered herein, including without limitation Realty Income Corp. (“O”, "O Realty" or “the Company”), and therefore stand to realize significant gains in the event that the price of its stock declines. Following publication of any presentation, report or letter, we intend to continue transacting in the securities covered therein, and we may be long, short, or neutral at any time hereafter regardless of our initial recommendation. All expressions of opinion are subject to change without notice, and Spruce Point Capital Management does not undertake to update this report or any information contained herein. Spruce Point Capital Management, subscribers and/or consultants shall have no obligation to inform any investor or viewer of this report about their historical, current, and future trading activities.

This research presentation expresses our research opinions, which we have based upon interpretation of certain facts and observations, all of which are based upon publicly available information, and all of which are set out in this research presentation. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purpose only and should not be taken as limitations of the maximum possible loss or gain. Any information contained in this report may include forward looking statements, expectations, pro forma analyses, estimates, and projections. You should assume these types of statements, expectations, pro forma analyses, estimates, and projections may turn out to be incorrect for reasons beyond Spruce Point Capital Management LLC’s control. This is not investment or accounting advice nor should it be construed as such. Use of Spruce Point Capital Management LLC’s research is at your own risk. You should do your own research and due diligence, with assistance from professional financial, legal and tax experts, before making any investment decision with respect to securities covered herein. All figures assumed to be in US Dollars, unless specified otherwise.

To the best of our ability and belief, as of the date hereof, all information contained herein is accurate and reliable and does not omit to state material facts necessary to make the statements herein not misleading, and all information has been obtained from public sources we believe to be accurate and reliable, and who are not insiders or connected persons of the stock covered herein or who may otherwise owe any fiduciary duty or duty of confidentiality to the issuer, or to any other person or entity that was breached by the transmission of information to Spruce Point Capital Management LLC. However, Spruce Point Capital Management LLC recognizes that there may be non-public information in the possession of Realty Income Corp. or other insiders of Realty Income Corp. that has not been publicly disclosed by Realty Income Corp.. Therefore, such information contained herein is presented “as is,” without warranty of any kind – whether express or implied. Spruce Point Capital Management LLC makes no other representations, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use.

This report’s estimated fundamental value only represents a best efforts estimate of the potential fundamental valuation of a specific security, and is not expressed as, or implied as, assessments of the quality of a security, a summary of past performance, or an actionable investment strategy for an investor. This is not an offer to sell or a solicitation of an offer to buy any security, nor shall any security be offered or sold to any person, in any jurisdiction in which such offer would be unlawful under the securities laws of such jurisdiction. Spruce Point Capital Management LLC is not registered as an investment advisor, broker/dealer, or accounting firm.

Disclosure: I am/we are short O.