by Travis Johnson, Stock Gumshoe | November 22, 2019 4:25 pm
Not a lot of buying and selling going on this week, as the market continues to seem to be reacting only to the “thumbs up” or “thumbs down” sentiment over a possible Chinese trade deal, but I did find one stock to buy… and caught up on a few others that have been catching my eye in the last week or so, mostly in REIT world.
So let’s start with our transaction, shall we?
Ulta Beauty (ULTA) — After keeping an eye on this stock for a while after I covered it in some detail in mid-October, I decided today, with the stock down another 7-8% since then, to take a position going into earnings (which should be reported in a couple weeks, on December 5). The stock took another small dip this week because of the Kylie Jenner/Coty deal (Ulta sells a lot of stuff from both brands, so I don’t know why investors would care that they’re combining), and because they had a promotion last weekend that reportedly fell a bit flat. I’m buying about half of the position I’d like to take right now, mostly just because I don’t want to make a specific bet on investor reaction to the next quarter — hopefully I’ll have a chance to fill out the position a bit following their next report.
The reason for some caution is that this is a big inflection time for Ulta, the stock could go pretty sharply either way in the next few weeks as they report what is seasonally always their weakest quarter but, more importantly, give an update on the first part of the holiday season and what they expect in that quarter (the earnings timing is odd because they have an odd fiscal year, their fourth quarter begins in early November and ends in early February, to keep all that holiday spending and marketing in the same report).
The bottom line? I think spending on and obsession with beauty is still growing, and Ulta is still the most accomplished and established national retailer, with decent same store sales growth, a good online presence, and a continuing store opening program that is keeping revenue growth pretty high… and it’s trading for about the same multiple as Target or Walmart, despite the fact that they’re likely to grow at least twice as fast.
It’s not a “no-brainer,” to be sure, particularly because investors are still very nervous after a couple meaningful forecast downgrades in the last year and worried about whether makeup and beauty are trends that are changing too fast for retailers to react, but I have faith in the American Woman’s willingness to spend on beauty products and services, and I think industry leadership is being underestimated here.
There are definitely some analysts who disagree, including some in Barron’s yesterday citing the risk that “changing makeup trends” will keep sales weak. And despite a couple generations of women in the Gumshoe family, I can’t really claim any unique insight or expertise on makeup trends… I’m mostly counting on the fact that spending overall will be strong, and a proven industry leader should be able to meet customers where they are, particularly in an industry like makeup and beauty services where there should be a distinct advantage in having a physical store presence.
Growth expectations are way down now, I think the odds are pretty good that they probably sandbagged a little and overestimated their challenges last quarter (when a weak forecast caused the shares to lose a third of their value), and the stock is trading at the lowest trailing PE it has seen since the 2009 collapse (and the lowest price/sales ratio they’ve been at since 2011). That doesn’t mean it can’t go down further, but I think they’re still a growing company and they’re no longer trading at a “growth” valuation — pessimism is overdone here for a sector leader and low-cost leader with a very strong brand and strong following.
If you want one indicator of where the stock is going, investors are definitely short-term focused but it won’t be the third quarter numbers that make a big difference — just look at the fourth quarter earnings forecast and how much it changes when they report earnings in two weeks. The current average analyst estimate is for $3.85 in that holiday quarter, cut from $4.25 or so a few months ago when ULTA slashed its guidance in the second quarter report. If it holds near $4 or rises, the stock will be recovering strongly… if it falls further, I imagine we’ll see a lot of tax-loss selling and, assuming I still like the overall trajectory for the company, maybe an even better buy price. Should be an interesting report.
I mentioned when I stopped out of most of my Arista position that I’d be curious to see how Cisco (CSCO) did, and this week we learned that their earnings were also weak, reinforcing the trouble that Arista Networks (ANET) is having with orders right now.
So the stock is near its low for the year, trading at roughly the level it was at through most of 2018 in the mid-$40s, and mostly it’s a question of how low it has to fall before it becomes appealing on a valuation basis among investors, like ourselves, who can handle being patient for a couple years. It’s getting close, though it’s always hard to buy a company whose earnings are declining — right now Cisco pays a dividend of over 3% a year and has been a consistent dividend growth company, and that dividend is less than half of quarterly earnings so is easily sustainable. They spent the past two years buying back a ludicrous amount of stock, roughly 700 million shares, only 10% of which (roughly) was to make up for the large stock grants they give to executives… and while net income probably topped out last year for a while, their revenue is still roughly flat (analysts see it declining less than 2% this year, and growing roughly 3% a year after that), so it’s not like the company is collapsing or obviously becoming irrelevant.
Cisco should be a beneficiary of the data center upgrade cycle, whenever that heats up again for 400G (still expected to really start to kick in next year sometime, though such forecasts have been wrong before), and is clearly dominant, with a strong security business alongside their core switch and router hardware, but it’s also true that CSCO shares have been through long periods of weakness in the past as the industry goes through long cycles. The shares could easily be roughly flat for a few years, the stock is trading at about a market multiple and is growing earnings more slowly than the average stock, so it might be that the dividend is all you can count on for a while. I’m still waiting and hoping that the shares get really depressed, I’m not in a rush to buy Cisco… but there will be another phase of growth, probably within a year or two, so if it gets too cheap to ignore I will hopefully notice. We’re not there yet, but the downside risk should be roughly similar to the broader market at this point.
I’ve been getting asked about pot stock MedMen (MMEN.CX, MMNFF) recently, and it occurs to me that this beleaguered marijuana retail brand is bringing the marijuana business kicking and screaming into the real world — and it’s not by choice. That’s the first US marijuana company that I’ve noticed talking about cash flow or profitability instead of “growth” and “building markets” and “valuable licenses” — they announced layoffs this week, which is such a boring “old economy” thing that it’s kind of shocking to see it next to the MedMen name, and they talked about a goal of “positive EBITDA” … here’s a little excerpt from the press release:
“We have a clear plan to increase our market share, while at the same time enhancing our margins and reducing our corporate overhead,” said Adam Bierman, MedMen co-founder and chief executive officer. “We must unlock our operating leverage and bring the Company to positive EBITDA. Given market conditions, capital allocation is more critical than ever. As such, we announced a layoff of over 190 MedMen employees. This layoff includes many hard working, mission-based people whose presence will be sorely missed. While it is never easy to let employees go from the MedMen Family, we believe this decision is in the best interest of our Company as we position ourselves for growth in the years ahead. We thank everyone for their hard work and dedication to MedMen, and we will now set our sights on achieving positive EBITDA by the end of calendar year 2020.”
And that’s probably the key comment buried in the middle there… “Given market conditions, capital allocation is more critical than ever.” The sudden loss of investor enthusiasm for pot stocks this year hit these companies hard, since many of them are so young that they had never seen a market where people weren’t throwing cash after pot stocks willy-nilly. The level of belief in the marijuana business as a “guaranteed winner” seems to me to still be pretty high, but a year ago it was ludicrous — and this MedMen news, along with the trouble that the Canadian pot companies are having as they too are faced with oversupply and weak margins and much lower sales than anticipated, means we should probably pause here and re-remind ourselves of a few things:
First: Predictions of market size or growth by industry or sector analysts are just estimates. And when it comes to brand-new businesses with lots of variables, it’s fair to call them guesses.
Second: You can’t tell exactly when investors will stop caring about top-line forecasts and start caring about bottom-line results, but when it happens it sometimes happens really fast.
Third: You should think a lot about the downside when you’re buying a “story” stock (which includes pretty much any marijuana stock these days) — what is there to support the share price if enthusiasm dwindles? Do they have actual earnings? A brand that is going to endure through hardship? Assets that would have value in the open market?
My personal feeling is that I wouldn’t touch MedMen at this point, they were riding on enthusiasm and brand awareness, fueled by massive amounts of cash that they raised easily near the peak, but if they stop investing the brand could easily wither — brands don’t build themselves, they need lots of marketing and a differentiated business to back them up. It still has potential, so if you’re a consumer in this space and you’re really convinced of the merit of MedMen over other brands, then you might want to take a flier on the shares now that they’ve dwindled so much… but I don’t have that sector expertise or the confidence in the brand that a consumer fan might have, so I’ll stay away.
Incidentally, the Oxford Club folks are still using the same “best American pot stock” teaser pitch to sell their newsletters, and it’s still teasing MedMen, I got the ad a few more times this week, though they haven’t updated the pitch to include MedMen’s disastrous performance this year. I first covered that spiel on March 26, here’s the chart of the stock since then (strangely enough, MedMen also went from almost all the analysts saying “Buy” in April to one lone holdout now)…
Though despite the specific problems MedMen has had (management controversy, deal with PharmaCann falling through, the strong black market in their key state of California), it’s clear that this is not primarily a company specific problem — all the pot stocks, US and Canadian, have come off their bubble highs and, so far, show no signs of getting that lustiness back. The US marijuana ETFs and the big Canadian pot stocks have all come down about 60% while MedMen fell 80%, so the tough operational issues are really just making MedMen perform a little worse than what was already a very bad sector.
And, as seems to always be the case, I had a bunch of REIT-related stories catch my eye this week. It must be something about my overall market sentiment, but I’m ever more drawn to dividends and real assets these days.
Ventas (VTR) caught my eye thanks to the precipitous decline in the shares after the last earnings report — this is a stock that I sold on a stop-loss back in January of 2018, at just about the same price it was trading for earlier this week ($58 and change), but I’ve always thought they were pretty well-managed and appealing, so what’s the story now? I don’t have any repressed anger about Ventas, I don’t think, I did post a decent 25% gain in the two years I held the stock, so can I look at it fresh now?
Probably the biggest problem for Ventas over the past couple years, from an investor perspective, is that they went from acting like a steady dividend growth company, lifting the payout by usually at least 5-10% per year, to a “dividend growth in name only” stock that over the past couple years has announced dividend increases of 1.9% in last 2017, which was tolerable but disappointing, and, last year, a truly embarrassing increase of 0.3% (they increased the annual dividend by a penny, from $3.16 to $3.17, as small as you could do with a straight face). That technically keeps them in the “raises the dividend every year” lists, but that’s a little like saying the guy who drops a quarter in the Salvation Army bucket is signing the Giving Pledge… or, perhaps more accurately, it’s as cynical as the CEO’s and CFO’s who get together to buy a handful of shares at the same time just so their company shows up on “insider buying” lists.
Ventas is one of the largest REITs in the world, with a $20+ billion market cap, so it is widely followed whenever anything happens — and the headlines tell most of the story, like Barrons‘ “Ventas Stock Decline Is a Warning to Yield-Hungry Investors”
Here’s what I wrote about Ventas when I sold my shares in January, 2018, just to check back on my thinking at the time…
“I think Ventas (VTR) is pretty fairly valued at this price (at about 15X trailing Funds From Operations, and with a 5% yield). The dividend growth slowed markedly this year, the increase for December (payable next week) was only 2%, following a 6% dividend increase in the previous year and a compound annual growth in the dividend of 8% over the past 15 years or so.
I don’t think they’re likely to have a surge in FFO per share… though the tax cut will benefit them as well — they did not get any bad news from the tax legislation, such as the rumored penalties for high-debt companies, and they did get good news on the lower rate for pass-through company taxation, which reportedly gives the wealthiest REIT shareholders a 15%+ boost in after-tax dividend income. That tax benefit is significant for wealthier shareholders who own the stock in taxable accounts, but it becomes a much smaller benefit for investors who are below the top tax bracket, and is no benefit at all for those who own the stock in tax-deferred accounts… so it’s unclear to me how much of a marginal difference that will make in the share price. I’m not hugely optimistic that Ventas will be re-taking its old highs anytime soon.
Fighting against that impulse is my general conviction that I shouldn’t be selling healthy dividend-paying stocks, that such investments generally work out better if I hold them — though that’s a bull market sentiment, built on the knowledge that almost every investment I’ve sold over the past ten years is now higher than it was when I sold it. So I’m torn.
In that case, does other valuation info help me decide? VTR’s dividend yield has not been highly correlated with the 10-year Treasury Note over the past 15 years, but it has been more correlated with that rate over the past two years than at any time in the past, which makes me think that investors are trading the REITs as a group using ETFs, and just selling them off as interest rate expectations rise and buying them as interest rate expectations fall… which makes sense, given the extent to which the market is driven by index buying and selling (probably close to 50% of Ventas shares are held by extremely index-driven investments, like ETFs and mutual funds and the closet-indexing “active” funds).
And Ventas has always had a substantially higher dividend yield than the average REIT (using the VNQ ETF) — except for this year. The two securities both had essentially the same trailing dividend yield for most of 2017, after a decade or more during which VTR had a yield that was, on average, almost 2 percentage points higher than the REIT index. With uncertainty over health care costs added to the general concern about rising REIT yields, it’s easy to imagine that gap re-opening. If VTR were to yield 2% more (200 basis points more) than the REIT index, that would be a yield of 6.3%… and at that level, VTR shares would be at $50. That’s a meaningful “downside risk” number, and it would mean VTR could feasibly fall another 16% without any drastic exogenous shocks or changes.
So what to do? Given that possible downside of 15% and a limited upside of probably also 10-15%, as I see things (mostly because of the slowed pace of dividend growth, which as of the most recent increase is no longer keeping up with CPI inflation), I decided to let the forced discipline of the stop loss make my decision and sell those shares.
That sell hits the Real Money Portfolio at $58 and change, meaning the gain on that position was close to 25% over an almost-2-year holding period — far below the return of the S&P 500, as you might imagine, but a bit better than the REIT index for that time period. That position is in a tax-deferred account, which is where I have generally preferred to stash my REIT holdings (at least until this latest tax cut for REITs, which might change my thinking), so taxes aren’t a concern — my calculus might have been different if I had to pay taxes on the gain.”
Today? Ventas is within a dollar or so of where I sold in early 2018, and is back to yielding almost 230 basis points more than the REIT index (VNQ, the REIT ETF I tend to follow, yields 3.1% now, Ventas has a trailing yield of 5.4%), so you are again getting a premium for taking the risk in this individual REIT.
What’s the issue? It seems mostly to be that Ventas’ Senior Housing business is suffering at a time when you’d think they’d be in the demographic sweet spot… here’s what the CEO said in the quarterly update:
“Ventas delivered strong enterprise level results in the third quarter, driven by our diverse portfolio including robust performance in our Medical Office, Healthcare and Research & Innovation portfolios, our high quality and accretive investments and effective capital markets execution. We have maintained the midpoint of our normalized FFO per share expectations for 2019, and we continue to invest in our future.
“Given challenging senior housing market conditions, our senior housing operating portfolio did not perform consistent with historical patterns or our expectations in the quarter, a trend we expect to continue for the balance of the year. As a result, while national leading indicators of supply and demand in the senior housing sector continue to improve, giving us confidence in the powerful upside that lies ahead, we have reduced our 2019 property level guidance for our senior housing operating business. This changed expectation leads us to conclude that our return to enterprise growth will occur after 2020.”
And it’s that reduced guidance for the rest of this year that probably really caught the attention of investors, who sold off the stock on the lower expectation, but it’s the “return to growth will occur after 2020″ that worries me. They seem to be basing that on the fact that although there was a boom in building senior housing and that led to competition and falling occupancy this year, they see that construction of new projects is tailing off because not as many units “broke ground” recently, which gives them hope that competition will be less aggressive in the future. That seems a bit squishy.
Still, they’ve managed through tough conditions before… and this doesn’t seem like it should be all that bad — they have some really interesting projects in other areas as well, building out space for a nursing school and for urban senior living locations that I would assume are in high demand, and being diversified means that they can pull those levers and invest in more appealing segments when one of them is doing poorly. They’re getting solid returns on their latest deals, in the 8-10% range, though the company is also getting more complex and harder to predict as they diversify.
Even with that diversification, though, senior housing is a big part of Ventas’ income, over 50% (33% from operated facilities and 21% from triple-net leased facilities)… though they have also proven in the past that they can get out of less-profitable or more-challenged businesses, like when they spun off their skilled nursing facilities into a new company (Care Capital Properties, back in 2015, which was bought by Sabra Health Care a couple years later). You never know for sure how different mini-sectors like that will perform, though — Ventas has been a better bet than Sabra (SBRA) over the past five years, but just barely, and Omega Healthcare (OHI), another skillled nursing REIT (and another former holding of mine), has done much better than both, mostly because of the power of compounding what were very large dividends for a while (OHI still pays more than VTR, with about a 6.5% dividend yield).
So now, Ventas is still a demographically interesting company that should have the opportunity to grow in 2021 and beyond, but analysts are expecting that the bounce-back won’t be immediate — they’ll see their funds from operations (FFO) drop by about 6% in 2019, and stay more or less flat for 2020 before they “pivot” back, they think, to growth.
I thought this was a good time to remind ourselves that future forecasts based on a turnaround strategy or an idea are not things you can take to the bank. The past and the present are pretty well-known, though interpretations may be different… the future, though, is a whole ‘nother thing.
My favorite recent reminder of that, of course, is WeWork and the debacle that company turned out to be for its major backer (and now rescuer), Softbank. So whenever I see a turnaround plan or a talk of “pivot” from a company that has hit a rough spot, I hope I’ll remember to revisit these slides from Softbank’s presentation of a couple weeks ago. They are almost the perfect examples of talking to investors like they are idiots, which probably works most of the time.
Here’s the first one… I call this, “making more money and spending less money leads to higher profits”
This next one is the chart that illustrates how this will work — the best part, of course, is the complete absence of any units or labels for the X or Y axes on the chart…
No, wait, I take that back — the best part is the single small-font, greyed out “event” in the chart, I circled that for you in red…
To be fair, those are among the more ridiculous slides from the Softbank presentation… but the rest of it was pretty eye-opening as well, you can see the whole thing here if you like.
And yes, I am weak and small and therefore I like to be reassured of good past decisions I’ve made, so I did go back and check to see how my one remaining healthcare REIT, Medical Properties Trust (MPW) has done compared to these two that I sold out of over the past few years, OHI and VTR… here’s that total return chart…
Of course, I would not have felt quite so compelled to show you that if the results were different… though I do still like MPW better than VTR and OHI, I’m beginning to think again about adding VTR at some point if it continues to be weak. Ventas has historically fought its way out of a lot of nasty problems and come back each time, with good leadership and a portfolio that’s probably better than it looks right now.
It’s not likely to be a “big upside” REIT anytime soon, particularly since I imagine they’ll again be quite parsimonious with their next dividend increase announcement (which should come in early December), but I’m also thinking that they will survive, they can afford to keep paying the dividend even if they can’t afford to grow it very aggressively at the moment, and the downside risk seems a lot more muted at this price. Hopefully we’ll see some selling after the dividend announcement, or as folks do some tax-loss selling, and the price will get “silly cheap” later this year — I’ve got my eye on the low $50s, about 10% below where we are now, and will particularly pay attention to the next dividend announcement.
And on the topic of REITs that I used to own but don’t anymore, I was also reminded this week of Retail Opportunity Investments Corp (ROIC), A REIT that was formed out of a SPAC about eight years ago and showed great promise because of its focus on the West Coast and on “necessity retail”, but also was particularly appealing because of the “retail royalty” running the show (Stuart Tanz, who had generated huge shareholder returns with a similar REIT a few years previous) and the fact that Tanz and other insiders had “skin in the game” with big equity stakes. And it worked well for a while, and was and is a solid company, owning mostly open-air malls that are anchored by grocery stores and pharmacies.
There was some challenge to the sector starting a few years ago, to be sure, largely catalyzed by the Amazon takeover of Whole Foods and the general struggles of the grocery store industry, but when I look back and think about what really happened to the stock it again comes down to dividends. REITs have returns that are almost always almost completely determined by their dividends — so high-yielders usually stay roughly flat and provide most of their shareholder return through those dividends, and the best REITs grow the dividend steadily (and preferably pretty aggressively) and see the share price move up with the dividend.
I sold my ROIC shares when it hit a stop loss about two years ago, in October of 2017 at $18.38 per share, and though I am typically reluctant to sell dividend-paying stocks that sale on a stop loss was made pretty easy… here’s what I wrote at the time:
“Retail Opportunity hit its stop loss trigger on Wednesday when it closed below $18.60, and after using that alert as a reason to investigate it more thoroughly I decided to allow that stop loss to work, and I sold my shares. This has been a long-held position, I’ve been letting my ROIC position compound since 2011 (and have added a few times along the way… and enjoyed a nice run from the warrants before then). I do like the company, but I looked through it with fresh eyes today and don’t find a 4% yield compelling enough given what I see as their limited ability to increase the dividend.
“It’s not a bad stock, to be sure — management is excellent, and CEO Stuart Tanz probably knows more about buying West Coast shopping centers and increasing their value over time than anyone else alive, but dividend growth has been slowing (the last increase was about 4%, each increase has been lower than the last) and there are structural concerns about the industry in the changing retail environment. That doesn’t mean grocery stores and pharmacies are going to disappear overnight, which was the fear that sent ROIC falling earlier this year when Amazon bought Whole Foods and all the grocery stocks cratered (most of ROIC’s shopping centers are anchored by grocery stores), but it does mean there’s risk of more upheaval in that industry… which could keep a lid on rent increases and/or the customer traffic that keeps ancillary rents at shopping centers rising (like the rent for the dry cleaner next to your grocery store, etc.).
“I expect ROIC will probably be fine, but the combination of rising interest rates (likely, but far from certain — the end of the bond bull market has been predicted dozens of times over the past decade, always incorrectly), some industry risk, an inability to meaningfully accelerate growth in FFO per share or dividends per share, and a mediocre current dividend of 4% are tepid enough for me to let the market tell me what to do and sell the shares at this stop loss level. I think the only likelihood for a real surge in ROIC is if interest rates fall markedly again and investors are suddenly willing to again accept a 3% yield from a slow grower, or if they get taken out by a larger REIT, which doesn’t seem all that likely to me (but is always possible — that’s how Tanz cemented his first fortune, by generating a lucrative buyout for his last REIT).
“If a stock I think has better potential than the market thinks hits a stop loss because of investor overreaction, I may actually ignore that stop and buy more if I think it’s undervalued (or at least hold, as i did with MPW when it hit stop loss alerts a couple times over the past two years)… but in this case I think the market probably has ROIC pretty much right here, and I’ll take the wisdom of the crowds and sell my shares. We’ll see how it turns out. My guess is that we will not see dramatic downside or upside for ROIC over the next six months.”
I was wrong on that, the stock did see pretty dramatic downside about six months later when it fell another 15%, but it has since recovered much of that… and is now only about 4-5% below where it was when I sold the stock two years ago.
And why is that? Well, I would argue that it’s almost entirely because their dividend growth and FFO per share growth stayed extremely low (and FFO per share even fell some of the time). Here’s a look at the two worlds — the growing REIT that was also growing its dividend from 2011-early 2017…
ROIC Dividend Per Share (TTM) data by YCharts
And the moribund stock that has been posting just token dividend growth since I sold in the fall of 2017…
Writing about your investments is both a blessing and a curse — it’s a curse because writing publicly about positions generally gives you more of a short-term focus, because no one likes to look like an idiot in public, but it’s also a blessing because it means you have to think through decisions and be able to explain them rationally, which tends to help you avoid (some) stupid decisions… and, as I’ve been finding this week, it’s a blessing because I can go back and review the arguments that I made a year or two or five years ago and see if those strategies hold water, or if I can learn something from things I wrote years ago and have since forgotten.
And the lesson that keeps coming back to me is, when it comes to REITs, focus on the dividend. Yes, the underlying performance of the company is important, revenue matters and debt matters and FFO matters, and yes, they can screw up, but the ideal situation is a REIT that has a near-average dividend yield but unusually strong dividend growth… that almost always leads to strong returns.
So these are the rules of thumb I’m trying to keep in mind these days when it comes to REITs and similar dividend-paying stocks. They are, of course, not perfect, and significant changes to interest rate expectations will matter a lot more to most REITs than any company-specific metrics, but hopefully it will help me to remember that dividend growth is the single most important factor when evaluating REIT stocks.
Speaking of REITs, I thought I’d take a quick look at a crazy-sounding one that went public earlier this year… and it caught my eye mostly because it just hit the expiration of its insider lockup period, and I always like to check in on new companies that are exiting their lockup because sometimes they take meaningful and undeserved dips if insiders decide to cash out in a big way.
This new REIT is called Postal Realty Trust (PSTL). It’s extremely small, with a market cap around $85 million, and a very odd and specific focus (yes, they buy properties that are leased to US Post Office locations).
This year, they say that they have closed on 95 properties for $28.4 million and have another $28 million under definitive agreement… which they think will contribute $5.1 million in annual rental revenue, which would mean that they’re getting rent that’s about 9% of their investment. That’s not bad, and they say their “expected weighted average cap rate” is between 7-9%, which is certainly better than some REITs… though a company with just one tenant, whose revenue is declining markedly and whose star seems to be declining in the halls of Congress, is far riskier than a company with a diversified tenant base. Even if that one tenant is the US Post Office, and we can’t imagine the USPO ever going out of business or failing to pay its rent.
With REITs we should look at several things to understand the big picture — are the tenants likely to keep paying rent; does the landlord have enough market power to increase the rent over time; are they offering triple net leases or do they have any responsibility for near-term operating expenses or real depreciation costs (for maintaining the buildings); can they grow the portfolio or increase per-share cash flow; are there any economies of scale available to make them more efficient as they grow; and, as part of that potential for growth and efficiency improvements, what’s the cash return on their properties compared to the cost of capital?
PSTL recently announced their first “real” dividend, 14 cents a share (they paid a tiny one in their first quarter, but it was only six cents and they owned very few properties by that point), so that means the current forward yield is about 3.5% at $16 a share. And the dividend is roughly covered by adjusted funds from operations (AFFO), so it should be sustainable and the hope, of course, is that it will grow as they increase the size of their portfolio.
Ideally, things could scale pretty well as they issue shares (at an effective cost of 3.5%, for the dividend) and use their credit line (which is at LIBOR plus about 2%, it appears, so probably about 4%), and use that to buy facilities that have a cash return of about 8% a year. All that’s required is math to figure out how much of a portfolio they need like that, generating cash returns after cost of capital in the 3-4% range, to cover their operating costs. It’s a moving target, since they haven’t been around long enough to really have a sense of what their “normal” run rate of overhead might be, and their general and administrative expenses have so far grown faster than the revenue, but that’s what I’ll look for once their larger acquisitions this year begin to trickle down to the income statement.
And the major risks beyond that financial sustainability issue? There are two that stand out for me, short lease periods and “related party transactions.”
So far, it looks like the properties they’ve been buying have mostly pretty short-term leases with the USPS, with remaining terms averaging only about three years… which means that if the Post Office decides (or has it decided for them) to cut back again on locations and close down a meaningful number of post offices, PSTL might be stuck with some properties without tenants. Maybe they are storefronts that would be easily leased to someone else, that would require a detailed look at the portfolio and some local retail knowledge, but I imagine there probably aren’t a lot of easy replacement tenants for a lot of those properties — Post Offices are often fairly specialized properties, so it would likely require some meaningful work to make them appealing to other tenants.
More than anything else, I’d be a little concerned that PSTL has largely been buying properties from knowledgeable owners, including owners who are related to the management of the REIT, and it might be that they see the writing on the wall regarding the Post Office’s future real estate needs and feel the need to get out. Most of the properties were originally owned by PSTL’s CEO and his family, so it could be that they see that the business works better at scale and they want to grow, and they need the currency of a publicly traded REIT in order to make acquisitions… or it could be that they want to continue controlling this large REIT portfolio but also want to start getting some of their capital out of the business and share the risk with other shareholders, which is much easier to do with a public company than a private one.
That’s not a judgement, just a note that this is basically a family-owned business that converted into a public REIT, and is often buying properties from related entities, so looking into those families and whether they’re buying and selling, or whether the prices they’re getting for those properties are benefitting themselves or public shareholders, is a reasonable next step.
I’m not tempted enough by the idea to dig much deeper yet, but it is an interesting little REIT, and interesting little REITs that can grow their portfolio quickly can usually also grow their dividend quickly once they grow enough to get sustainable access to growth capital (debt, or the ability to sell more shares at decent valuations), and, of course, dividend growth usually means stock price growth… so I’ll keep an eye on this one.
And that’s all we’ve got for you today, dear friends — have an excellent weekend, try not to think about whether or not there will be a China trade deal when you’re looking at your portfolio and making investment decisions, and remember to come back and enjoy more of our musings and blatheration next week!
P.S. I still think Tesla (TSLA) is a disaster of a public company, though I no longer have a long or short position… but I must admit, I love the audacity of the crazy new “Blade Runner” Tesla pickup truck, even if it never ends up making it beyond “concept vehicle” status. I put down my $100 deposit, and I would probably actually buy that ridiculous truck for $39,000 if that ends up being the real life situation in a few years when (if) it becomes available and my number gets called on the “waiting list”… if only to try to satisfy my inner 13-year-old’s passion for the DeLorean. I love Tesla’s influence on the car industry and Elon Musk’s passion for pushing forward the cause of electrification… even if I think he shouldn’t be allowed to run a publicly traded company. And no, I don’t care whether or not a bowling ball will bounce off the window.
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