SRC - Realty Income: Bigger And Better From The Merger With Spirit Realty Capital

2023-10-30 10:56:20 ET

Summary

• Realty Income Corporation is merging with Spirit Realty Capital, Inc. in a $9.3 billion all-stock deal, accounting for 15% of Realty Income's market cap.
• The deal poses theoretical risks for Realty Income, including paying above the fair value of the joint business and the challenge of integrating large portfolios.
• Yet, the merger is expected to have positive immediate effects on Realty Income's organic AFFO on a per share basis. The bar for immediate synergies is low.
• The most important takeaways for long-term investors is that through this merger, Realty Income will become better capitalized and larger, which will allow to negotiate better terms with lenders.

Today, Realty Income Corporation ( O ) announced that it will be fully merging with Spirit Realty Capital, Inc. ( SRC ) in an all-stock maneuver valued (enterprise value basis) at ~$9.3 billion, where the SRC's stock is priced at ~15% premium to the last closing day before the announcement.

This deal accounts for roughly 15% of O's market cap, rendering a notable impact on the underlying business and cash flows. It also marks O's largest deal since the merger with VRET back in November 2021.

As it often is the case, after the announcement, O's stock price dropped a bit, while SRC's increased in a magnitude that directly corresponds to the paid premium.

Whenever such large transactions take place, there are some inherent risks, especially for the buyer side.

A clear one is paying above the value that could be extracted via the acquisition, where each cent above the fair share price of joint business (integrated SRC) imposes a significant impact on the like-for-like wealth creation to the existing shareholders.

The second one, which is less observable or quantifiable is the ability to unleash synergies. There needs to be a well-calibrated integration plan to combine large portfolios and through efficiencies secure some cost savings. Again, adding ~15% of the business is not a simple task and each mistake here could lead to notable consequences.

My personal preference as an O shareholder would be to avoid such concentrated transactions, but let's review the deal logic and see whether this is a net positive for O.

Details of the transaction

As stated earlier, O will pay for the deal by issuing its own equity and exchanging it with the SRC's shareholders. This way, O will avoid an assumption of incremental debt.

If all of the necessary approvals are received, the deal is expected to materialize in Q1 2024. So, O's shareholders will most likely notice full quarterly effects starting only from Q2 2024 earnings.

By merging with SRC, O will be able to consolidate an additional ~2 thousand properties, which are primarily leased out on a net-lease basis just as the majority of O's portfolio.

In all of the industries, where SRC is present, O has already established portfolios that contribute to the synergetic potential.

In SRC's case there is a bit heavier skew towards industrial properties (~25% of the total leases), which will fit nicely in the O's structure. This is especially a positive sign considering ~12 years of weighted average remaining lease term on SRC's industrial properties, which are currently priced below the market level rents.

Moreover, through the merger O will also assume SRC's balance sheet , which, again, carries very similar characteristics to the O's structure.

Namely, it is an investment-grade balance sheet with no maturities until 2025. The net debt to EBITDA profile is also almost exactly the same as for O - i.e., at 5.2x.

All in all, the companies are fairly similar both on the business and financial risk level.

Positive for organic AFFO growth

Based on the O's commentary, the deal is set to be directly accretive to the underlying adjusted funds from operations, or AFFO. The management expects that post-merger, the combined AFFO per share will increase by 2.5%. The underlying driver here is ~$50 million in G&A savings, which is a prudent and relatively conservative take considering the size of both companies.

This assumption stems from purely mathematical calculus, which is obviously a positive thing for O's shareholders.

A 2.5% like-for-like movement in the context of the analyst's consensus estimate (before transaction) for 2024 and 2025 FFO growth is material.

Yet, the most important aspect in terms of the organic AFFO generation is the embedded potential within SRC's portfolio.

Currently, only ~6% of the SRC leases expire by 2025. However, starting from 2026 there will be more notable maturities, which will trigger more attractive leasing spreads allowing O to capitalize on the embedded pricing discrepancies between the market levels and what has been stipulated via historical contracts. The fact that both O and SRC have historically delivered positive like-for-like NOI figures (for already many quarters in a row) on the re-leasing front is a clear indication of the underlying value.

Lastly, we should be also aware that most of SRC's portfolio is subject to regular rent escalators that will provide a structural tailwind for organic AFFO growth on a go-forward basis.

Bigger is better in the higher-for-longer interest rate environment

By merging with SRC, O will become a more capitalized company with improved diversification effects. Importantly, the O will not become diversified with some additional risk exposures, but instead will strengthen its positioning with high quality portfolio that is 99.8% leased out for over a 12-year period.

There is a plethora of benefits that are associated with larger capitalization levels, but the three most important in the context of prevailing market dynamics are the following:

• Greater bargaining power with debt financers for whom size plays a significant role in the price (credit risk) discovery process.
• Improved liquidity of O's equity, which should help raise fresh proceeds via public and/or private placements.
• Better position in the eyes of credit rating agencies, which factor in the size and diversity of the credit issuers.

In other words, having a greater size, diversification and balance sheet per definition puts a well-needed downward pressure on the cost of capital.

In 2025 and 2026, when the first major refinancings will kick in for O (both for its own maturities and SRC's), the size aspect will come in handy, allowing the Company to save some basis points on new financing costs.

The bottom line

The businesses of O and SRC are fairly similar with a great degree of overlap. The structure of leases, types of properties, industries and balance sheets are relatively homogenous. This makes me less worrisome about O's ability to unleash synergetic value.

In addition, the structure of the deal provides an almost immediate benefit to O's shareholders on a per share basis. There is no additional financial risk assumed and the underlying assumption for 2.5% AFFO accretion is very conservative (realistic).

In my humble opinion, the most important aspect that investors should appreciate in the context of this transaction is the size angle. After the merger, O will become even more diversified and will carry higher capitalization levels, which will help better navigate first debt maturities in 2025 and 2026.

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