SRC - Realty Income's Spooky Halloween Surprise Spirit Capital

2023-10-31 19:00:20 ET

Summary

• We have a manic merger Monday!
• Realty Income decided to buy out Spirit Realty, offering a 15% premium from its last close.
• We look at how accretive the deal is and why Spirit's shareholders should not be too unhappy about the trade.

It was a manic merger Monday. First, we heard about Healthpeak Properties (NYSE: PEAK ) and Physicians Realty Trust (NYSE: DOC ) agreeing to merge in an all-stock deal. Then, we got to know about Realty Income ( O ) deciding that it wanted to get into the action as well by buying out Spirit Realty ( SRC ). We analyze this deal and tell you how you should play it.

The Deal

Under the terms of the merger agreement, Spirit shareholders will receive 0.762 newly-issued Realty Income common shares for each Spirit common share they own. At closing, this will result in Realty Income and Spirit shareholders owning approximately 87% and 13%, respectively, of the combined company. The merger is subject to customary closing conditions, including the approval of Spirit shareholders, and is expected to close during the first quarter of 2024.

Source: Seeking Alpha

Realty Income closed at $49.00 on Friday, October 28, 2023. So the 0.762 multiple gets us to a price of $$37.34 for Spirit. That is about a 15% premium from its last close. Of course, this is an all-stock deal so Realty Income's stock moving lower in conjunction with this reduces the joy SRC shareholders are feeling.

From Realty Income's Point Of View

When the company size becomes this big, growth is hard to come by. Realty Income had been trying more creative transactions of late (going abroad and buying casinos), but those were just not moving the needle. Also crimping its style was the fact that multiple on its stock (the price to funds from operations or FFO) was really low relative to the previous decade. You really cannot make accretive purchases based on that, especially when debt costs are exploding as well.

Spirit transaction though offered Realty Income some real additional scale. The market cap was decent ($4.5 billion) and both companies followed a very similar model.

But there are problems in accepting the accretive nature of the deal. The key issue here is that Spirit traded at a 15-20% discount to consensus NAV just prior to the announcement.

Realty Income was right there was well in the same discount to NAV category.

By doing a stock swap, Realty Income will be issuing more of its own stock at a solid discount. Since the discounts are about the same, you are not likely to get much mileage out of it. In fact looking at those two charts above it is amply clear that Realty Income often traded at a far higher premium to NAV than Spirit. Just before the pandemic for example, would be a great time to do a swap. Of course, we do not know if Spirit would have been amenable to it back then. It is possible the brutal bear market made the company relent to be bought out. Of course deals like this are always presented as the best thing since sliced bread and we go a little of that in terms of cost savings and synergies. But this won't be an earth-shattering deal for sure.

From Spirit Capital's Perspective

Your shareholders are generally not going to be too upset when you sell out to a blue chip like Realty Income. But many will question the timing. SRC has barely traded below the buyout price outside of the COVID-19 crash.

There was one solace here holding Spirit stock and that was the high dividend yield relative to the capital still employed. Even that gets taken away here post the swap.

How To Play It

If you were waiting to buy a Realty Income capitulation moment, you got it. The monthly dividend club that jumped in at the highs is now puking their guts out. The dividend yield is extremely high relative to its history.

We have generally been skeptical of buying Realty Income in the past, simply as the multiple has seemed unwarranted. Of course if you ask the perpetual bulls, every day is a great time to buy. They could see an asteroid headed for earth and their first priority would be to remind everyone about Realty Income dividend record. But we have to agree with them today. At the current price ($46.20) you are likely to have a good total return over the next decade. We are upgrading this to a buy though we are still weighing exactly how to mark our entry with the right covered calls.

If you own Sprit stock, there is likely little joy for you here in the buyout. Despite the lower yield, we don't think getting Realty Income stock will hurt in the long term. An alternative bid is highly unlikely but you of course need to hold the stock to get that. We had a buy rating last time around and we continue to have that on the REIT and we continue to have that as we price in dividends and the last little upside to the stock at closing. Of course we are now bullish on Realty Income so that factors in.

Spirit Realty Capital, Inc. 6% PFD SER A ( SRC.PR.A )

One quick note on the preferred shares. We had previously suggested owners of Global Medical REIT Inc. 7.50% CUM PFD A ( GMRE.PR.A ) upgrade to SRC.PR.A as it had a superior risk profile . SRC.PR.A is now up 12% as we write this. You won't be able to get your full par value redemption at the moment though as there is a surviving entity still listed and Spirit is not going private. That said, being part of Realty Income's capital structure means you are getting a credit upgrade.

Congratulations. This is of course the safest yield you can now find amongst REITs (a preferred share of the revered Realty Income) but based on price and current yield of 6.7%, we think you can do better elsewhere. We rate this a Hold.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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