SRRTF - Slate Grocery REIT: Q1 Earnings Confirm That Valuation Discount Is Unjustified

2023-05-08 08:49:28 ET

Summary

• Right before SRRTF announced its Q1 figures, I issued a buy rating indicating that SRRTF's valuation discount is unjustified against the backdrop of fundamentals and multiples of other peers.
• The release of Q1 earnings did not impact the share price despite the underlying cash flows being stable and like-for-like results revealing a favourable momentum.
• On a go forward basis, the buy thesis remains in tact as SRRTF is expected to protect the FFO figure against the surging interest costs by benefiting from double digit leasing spreads.

On May 1, 2023, I issued a buy thesis on Slate Grocery REIT ( OTC:SRRTF ) that was underpinned by the following dynamics:

1. Resilient FFO with a growth momentum. SRRTF's tenant portfolio is comprised of companies operating in durable and defensive sectors that inherently provide a protection against economic turbulences. Top 15 largest tenants, accounting for ~35% of the total rents, carry strong balance sheets and also generate cash flows that are relatively insensitive to the changes in the economy (i.e., non-discretionary segment).
2. High debt, but with already priced in impact. While SRRTF has relatively high leverage profile, compared to the other U.S. equity REIT peers, the debt and coverage metrics are in line with the benchmark averages. The fulfillment of debt covenants is strong, where, for example, SRRTF enjoys a favourable spread of 11% between the current leverage (49%) ratio and the one that is set by the lenders (60%). Finally, the average cost of debt for SRRTF stands at 4.3% implying that a major part of the negative rate of change in the interest has already been reflected in the current FFO figure. There are incremental 150 basis points (considering the recent financing terms stipulated by SRRTF) that still have to percolate through the books, but these effects are relatively minor in the context of underlying cash flow generation.
3. Unjustified discount. SRRTF trades at a ~35% discount compared to its peers operating in the retail equity REIT space ("free standing" segment). Given the positive momentum in the FFO and strong balance sheet, the discount seems to lack a reasonable basis.

(Please see more details about the aforementioned points in my previous article ).

Synthesis of Q1 earnings

In a nutshell, SRRTF delivered strong results on all fronts, where positive momentum in the underlying operations allowed to fully offset the negative effects from a continued convergence towards market interest rate levels.

There are five important elements that worth underscoring in order to get a sense of where SRRTF currently stands and where it is likely heading.

First , the occupancy level increased by 50 basis points from a quite tough comp of 93.2% (year-end 2022), which in itself was a historical high for SRRTF since the outbreak of COVID-19. The uptick of 50 basis points could be considered on a like-for-like terms given that no asset rotation or external growth activities were realized in Q1.

Second , and on a similar note, the like-for-like NOI increased by 3% compared to the Q4, 2022. The key drivers behind this movement were the embedded rent escalators, strong leasing spreads and slightly higher occupancy level.

Third , leasing spreads in Q1 were red hot. SRRTF did an excellent job in both the new lease and renewed lease front by stipulating extremely favourable spreads of 17.1% and 8.4%, respectively. These results also confirm a continuation of the positive momentum in the overall leasing activity, where SRRTF has managed to deliver growth in spreads for a third quarter in a row.

Forth , the tenant retention rates remained resilient, where 100% of grocery-anchored properties were resigned. This is a clear testament of the strong demand for SRRTF's properties.

Fifth , the state of balance sheet remained unchanged, which is fully in line with the precautionary steps on the M&A front assumed by the Management. However, while the capital structure did not change, the coverage metrics improved due to positive dynamics in the NOI front. For instance, the fixed charge coverage increased by 3.5% to 2.42x, and as of Q1, 2023, provide a significant headroom relative to the covenant level of 1.5x. Similarly, the weighted average cost of debt remained at 4.26% due to no debt maturities this year and favorable interest rate hedges.

The bottom line

Currently, SRRTF trades at P/FFO of 9.4x (on a forwards basis), which still implies a discount of ~35% relative to the closest peers. As a consequence of the massively depressed valuation levels, SRRTF's dividend yield is very attractive - 8.8%. Assuming that FFO remains stable over the 2023, the payout ratio stands at 83%. Typically, FFO payout above 75% is considered aggressive, in SRRTF's this should not be an issue due to already absorbed interests costs stemming from higher cost of financing levels, and given the strong momentum in the NOI figures.

FFO for 2023 should remain stable. And there are two major reasons behind this. (1) No debt maturities in 2023 , which allows to avoid suffering from incremental interest costs (albeit, everything to a large extent is already baked into the current figures as elaborated above). (2) Insignificant amount of lease expiries in 2023 , which decreases the uncertainty around occupancy rates. However, in my opinion, and the more lease expiries there are, the better for SRRTF considering double digit leasing spreads and success in the retention rate.

In my opinion, SRRTF is still a buy. The discount should gradually vanish as the Company continues to register stable results. Plus, while waiting for the thesis to play out, investors can count on ~8.8% dividend yield, which is significant above what other peers offer.

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