ONL - Orion Office Hits Our Fair Value Target Here Is What Comes Next

2023-03-10 07:40:14 ET

Summary

• We have had a clear bearish bias on Orion Office REIT Inc.
• ONL is down 50% since our initial call.
• The recent results do show that there has been some steadying of the ship, but will it last is what you need to know.
• We update our call on this one.

It is rare that you get a layup as perfect as Orion Office REIT ( ONL ). The stock had just been spun-off from VEREIT and Realty Income Corporation ( O ) merger and consisted of one of the worst setups that we could find. A bad asset class coupled with unrealistic expectations made the call particularly clear.

We went with a "Strong Sell".

Down the line we moved from a "Strong Sell" to just a "Sell". Think of the former as the "hand over fist" version of selling and the latter as just a run of the mill version of selling. In our last article we gave a price target for the next 12 months.

This is a "show-me" story and we will be happy to admit that we are wrong if Orion starts signing leases in a way that starts extending its weighted average lease term. Until then, we are sticking with a simple rule of not valuing this at more than 5 times FFO. As we roll out to 2023, we think $1.40 looks feasible and that gets us to $7.00 per share. We maintain our sell rating for now.

Source: Orion Office Remains A Value Trap

With the stock at $7.45 we decided to update our thesis.

Q4-2022

Orion's Q4-2022 was generally on target and funds from operations (FFO) came in a shade ahead of expectations. As always the thing to really watch was the occupancy level.

As of December 31, 2022, the Company's portfolio occupancy rate was 89.0%, with 73.3% of annualized base rent derived from Investment Grade Tenants, and the portfolio's weighted average remaining lease term was 4.1 years.

Source: Orion Q4-2022 Results

In Q4-2021, occupancy was 91.9%, but more importantly, it was based on 92 properties.

As of December 31, 2021, the Company had a real estate portfolio comprised of 92 properties, and a 20% ownership interest in a joint venture comprising six properties. The Company's portfolio occupancy rate was 91.9% , approximately 67.7% of the Company's annualized base rent as of December 31, 2021 was from tenants with an investment grade credit rating, and the weighted average remaining lease term was 4.1 years .

Source: Orion Q4-2021 Results

Today we have 81 in the consolidated portfolio as 11 properties were sold. So those sales went a long way into keeping occupancy levels looking solid. Sales were at low prices and at just 4.5X annual carry costs for these properties.

In 2022, we deliberately focused our resources on this strategy and closed on 11 sales of approximately 900,000 square feet for approximately $33 million. This equated to a price per square foot of about $36, both reducing existing vacancy and avoiding near term vacancy as the leases expire. 8 of the 11 properties were vacant as of the date of sale, and the remaining three had near term lease expirations where we knew the tenants were not renewing. We estimate that the sale of these 11 assets will allow us to save annual vacant property carrying costs of about $7.5 million.

Source: Orion Q4-2022 Conference Call Transcript

The management spoke about the level of renewals during the year.

During the quarter ended December 31, 2022, the Company entered into two 10.0-year lease renewals for a total of 213,000 square feet at two of the Company's properties in New York, one 5.0-year lease renewal for 90,000 square feet at one of the Company's properties in Lawrence, Kansas, and one 5.4-year lease renewal for 4,000 square feet at one of the Company's properties in The Woodlands, Texas.

Including leasing activity during the nine months ended September 30, 2022, the Company entered into new leases or lease renewals for 764,000 square feet of office space across 10 different properties during 2022 and has entered into a lease expansion with an existing tenant at one property covering an additional 41,000 square feet.

Source: Orion Q4-2022 Results

Context is important and for Orion that context comes from putting the 800,000 square feet of renewals during the year in relation to its total square footage.

With 9.73 million of square feet and a weighted average lease term of 4.1 years, investors should see about 2.37 million square feet of renewals every year (or 600,000 square feet every quarter), to keep occupancy and weighted average lease maturity stable. So the 800,000 square feet during the year and 200,000 square feet during the quarter, falls painfully short. Now some of these are longer leases than the current 4.1 year average, and that helps, but overall, Orion continue to struggle on this front. Furthermore, 40% of the portfolio comes for renewal in the next 2 years and this will be difficult to navigate.

Management plans on a lot more sales to deal with this as the carry costs of vacant properties are extremely high.

Gaurav Mehta

Okay. You also talked about marketing additional 500,000 square feet of properties, are you expecting any sales this year? Or your expectation is that majority of the sales would be next year?

Paul McDowell

No, we expect to have a significant, relatively significant number of sales this year. And then next year, the big sale candidate would be the Walgreens and we've discussed that we hope will sell in the very beginning of 2024. But in 2023, we have a number of properties currently in the market. And we expect to sell a relatively significant number of those during the course of the year.

Source: Orion Q4-2022 Conference Call Transcript

Verdict

Management had a $50 million stock buyback in place but did not use it at all.

Partially to maintain maximum liquidity in the current environment, the company did not repurchase any shares in the fourth quarter though it was previously announced $50 million open market repurchase program.

Source: Orion Q4-2022 Conference Call Transcript

This is actually the correct call as despite the strong cash flow over the horizon, they are rapidly losing cash-flow generating ability. Their adjusted EBITDA for example has dropped from $34.9 million in Q1-2022 to $30.7 million in Q4-2022. What is a bit puzzling here is the guidance for 2023. It does appear a bit better than what we would expect given the leases that are up for renewal. The anomaly could be coming from the possibility that these renewals are later in the year and won't impact FFO too much for 2023. Of course that would mean that 2024 would see the big showdown. So far asset sales have been at really poor prices. If we extrapolate the 900,000 square feet of sales getting $33 million to the rest of the portfolio, even two-thirds of the debt would not be covered.

All properties are unique and there are of course guaranteed cash flows with the current leases. But the dilemma here for management is how to navigate the current situation. Investors get hung up on the low multiple of FFO without even thinking through how little value a property has when it loses its tenant. This is most true for single tenant office properties which are extremely unique and very difficult to cross sell. Capex also could ramp up materially as properties are improved for new tenants. In Q4-2022 Orion spent 26% of FFO on capex and leasing commissions. Those are big numbers and just based on that your multiple would expand. We had suggested 5X FFO as a fair value for Orion and based on their 2023 guidance, we are already there. Normally we would upgrade this at the current point to a "hold" rating. But we don't think the damage is done. The relatively low lease renewals done in the quarter and the asset sales should keep bulls on the defensive. We think we will see $6.00 at some point in 2023 and are maintaining a sell rating.

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