SRC - Realty Income Acquires Spirit: Trouble With The Curve

2023-10-30 10:20:38 ET

Summary

• Realty Income Corporation has thrown a curveball in acquiring Spirit Realty Capital, Inc., diluting current shareholders, but this is expected to be accretive on a leverage-neutral basis.
• The merger will result in increased diversification and lower rent concentration for Realty Income.
• Following the merger, Realty Income will become the 4th largest REIT in the S&P 500 by enterprise value.
• We think this price is a steal for Realty Income given Spirit shares have plummeted in recent weeks, but are adjusting to what it means for future performance.

You know the saying in baseball, when a big power hitter crushes fastballs, but can't make it out of single A or independent ball? Usually it is because they cannot make the adjustments to breaking balls. And they then struggle mightily to hit for average against them. We call that trouble with the curve. There was a decent movie with Clint Eastwood and Justin Timberlake with the same title.

Well, today, we are having trouble with the curve. This is because Realty Income Corporation (NYSE: O ), which we moved from short to buy earlier this month, just dropped a nasty breaking pitch across the plate, in announcing this morning that they will acquire Spirit Realty Capital, Inc. (NYSE: SRC ). We were setting up to make an adjustment when earnings were reported.

You can see our expectations here: Trick Or tREIT: What You Need To Know About Realty Income .

This transaction has a strong rationale. Mind you we have seen some weakness of late, as back in Q2 net income was $195.4 million, or $0.29 per share, while adjusted funds from operations ("AFFO") was $1.00 per share. Not weak, but not all that strong, either. And there is leverage. At the end of Q2, net debt to adjusted EBITDA was 5.3x on an annualized. The company had $3.5 billion of liquidity, which consisted of cash and cash equivalents of $253.7 million to start Q3.

One of the things that we called out in our expectations column was as follows

"We see the company continuing to seek out investment opportunities that have strong future growth characteristics having CPI-based rent escalators that are uncapped. That feature is actually present in nearly 30% of the leases in the international portfolio. This will be a key source of growing same-store rental growth as well as overall revenue growth long term. Updates from management on what they are doing to push meaningful contractual rent escalators on the call will be key."

So, we were looking for an update on earnings regarding future investment opportunities, but this definitely came as a curveball. In reviewing the operations of Spirit Realty this morning, we can conclude that the transaction will result in sizable AFFO per share accretion on a leverage-neutral basis and offer cost synergies. Relative to its standalone annualized AFFO per share run rate. In the release of the news , Realty Income estimates the transaction to be over 2.5% accretive. Since both companies are levered, the post-transaction leverage will be about 5.5X,.

Now here is the deal. It is dilutive here, as this is an all-stock deal. Realty Income is not using any of its cash on hand. With the merger agreement, Spirit shareholders will receive 0.762 newly-issued Realty Income common shares for each Spirit common share they own. At the end of the day, current Realty Income holders will own 87% of the newly combined company, to give you an idea of the combined impact of the dilution. The merger will need the approval of Spirit shareholders, and is expected to close during the first quarter of 2024.

Sumit Roy , President and Chief Executive Officer of Realty Income, specifically called out cash flow. This is a curveball we are trying to adjust to, because cash flow is king for the hefty dividends:

"Spirit's assets are highly complementary to our existing portfolio, extending our investments in industries that have proven to generate durable cash flows over several economic cycles...our technology and infrastructure investments following the VEREIT merger in 2021 have amplified our efficiency in integrating assets and augmented our capabilities in maximizing the value of our properties."

This is what we find interesting: durable cash flows over several economic cycles. Since we are in part of the cycle that is painful, the timing of the merger has us a bit struggling to adjust, but perhaps this was in the works for some time behind the scenes.

In spending the morning reviewing Spirit Realty and its portfolio, while the timing of this pitch has us struggling at the proverbial plate, we can conclude that Spirit does, in our opinion, have a complementary real estate portfolio to Realty Income's, and we believe it furthers the diversification of holdings. The big positive here is that it will lower rent concentration for nine of Realty Income's current top 10 industries and 18 of its current top 20 clients. Moreover, it is a near 20% boost to Realty Income's annualized contractual rent, which will balloon to $4.5 billion.

The reason we liked Realty Income after the slaughtering of shares was its stable and economically resilient tenant base, and namely that convenience stores were the largest industry, at 11.1% of the port. Following the merger, there will be more diversification, and while convenience stores will remain the largest industry, the concentration is reduced to 10.2% of annualized contractual rent. We have mixed feelings on this, but at the end of the day we believe more diversification is a net benefit, even if it reduces the concentration of convenience store rent.

Following the closing of the merger, Realty Income will grow to the 4 ^th largest real estate investment trust, or REIT, in the S&P 500 (SP500), by enterprise value, with a total enterprise value of approximately $63 billion. While Spirit shareholders have to approve this, one last wrinkle on this curve is that Realty Income shareholders will not vote on the merger.

So, we have an all-stock deal here to acquire a full company's portfolio. The move was about a 15% premium to Spirit's value at the end of last week. But at the end of the day, it is actually a bit of a steal, as SRC shares were at $42 in August! This deal values SRC around $37. We think it is a curveball, but one that we can put solidly in play. The next catalyst for shares will be Q3 earnings ( expected post-market on November 6th).

Our Q3 expectations again are for quarterly revenue of $985 million, net income of $200 million, and to generate funds from operations of $1.02. The same-store rental revenue is also key, and we are looking for $715-$725 million on this front, with remaining revenue from other activities including new lease origination, lending, etc.

Your voice matters

What do you think of this transaction? Is it odd to not get a vote? Do you think it will be as accretive as projected? Do you agree that it was a bit of a steal? Do you find the timing odd? Let the community know below/

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