2023-11-06 16:07:18 ET
Summary
- Movie theatres are recovering, EPR has negotiated a great deal with Regal and consequently rent coverage is at pre-Covid levels.
- In the meantime, the stock remains discounted with a 7% dividend yield which is entirely covered even if we exclude movie theatres.
- I present upside expectations based on various interest rate scenarios and suggest investing in preferred shares due to a superior risk-reward.
Dear readers,
EPR Properties ( EPR ) is a unique REIT focused on experiential properties.
Their portfolio mainly consists of movie theatres (39%) and eat-and-play concepts such as Topgolf or go-karting (24%), followed by other attractions such as waterparks and ski resorts.
The portfolio has been understandably hit hard by Covid closures. Since then, movie theatres have somewhat recovered, but the recovery has been slow and has resulted in some of EPR's major tenants - especially AMC and Regal - struggling to pay rent. This has understandably spooked the market, because combined these two tenants account for 27% of total rent revenue.
Last time I wrote about the stock, I showed you that at $41.70 per share, the market has written off 85% of EPR's movie theatre business, creating a massive margin of safety. Consequently, I issued a BUY rating for the common shares and suggested the Series C preferred shares ( EPR.PR.C ) as a good alternative for more defensive investors.
Since then, the theatre segment has continued to recover and EPR has made progress on their negotiations with Regal. As a result, the stock has outperformed the index with a total return of about 12%.
I believe there's more upside here and the stock provides a great way to boost one's dividend income with a 7% well-covered dividend yield. I want to go over EPR's most recent Q3 performance and show you how much upside potential there could be depending on various interest rate scenarios.
Recent Performance
It's best to think of EPR in two parts. The movie theatres and the rest of their experiential portfolio. I'll get to movie theatres in a minute, but before that I want to emphasize that the experiential portfolio which accounts for 61% of revenue is doing extremely well. People like to spend on experiences these days and as a result, the segment's rent coverage has improved from 2x pre-Covid to 2.6x today, despite significant increases in rent.
The theatre business admittedly remains the weakest part of EPR's business, but is seeing significant improvements as well. Over the first 9 months of the year box office revenue increased by 26% YoY to $7 Billion and has already surpassed full year 2022 levels. In Q3 alone, the year-over-year increase was even larger at 38% YoY, driven mainly by the successful release of Barbie and Oppenheimer. For the full year, management sees a clear way to $9 Billion, up 24% YoY.
On a company level, EPR has successfully closed a restructuring agreement with Regal which will be anchored by a new master lease for 41 of the 57 properties previously operated by Regal. The remaining 16 properties will be released or sold by EPR. The agreement is very good for EPR. It ensures $65 Million in annual fixed rents, in addition to turnover rent on Regal's revenue over $220 Million, a threshold likely to be crossed in 2023 (it was crossed even in 2022 with box office revenues of $7.4 Billion). Moreover, the master lease has landlord friendly lease-terms, increasing the lease term to 13 years (vs 9 years previously) and locking in solid 10% rent escalators every five years. Overall, in 2024 EPR expects that the 41 properties under the master lease will generate 96% of rent previously paid by the 57 properties. And more will likely be made over time as the REIT finds a way to monetize the remaining 16 properties.
Adjusting movie theatre rent coverage for the Regal restructuring deal, coverage for the trailing 12 months would be at 1.5x. With overall box office revenues expected at $9 Billion this year, management expects coverage to reach their long-term average (pre-pandemic) coverage range of 1.6x to 1.8x.
It's clear that movie theatres are recovering and I believe they are here to stay. The simple reality is that there's no better way to monetize blockbuster movies effectively as streaming provides a very different experience. Apple ( AAPL ) and Amazon ( AMZN ) have committed to investing a Billion dollars each into theatrical movie production which should ensure a healthy line-up of successful releases for years to come. I fully expect smaller and older theatres to struggle and eventually close down, but EPR owns some of the best theatres in the nation and innovates by incorporating various F&B concepts, luxury seating and more. As a result, I expect EPR's movie theatres to do well and operate with a healthy rent coverage of 1.5x.
If tenants pay their rent, the REIT really doesn't have much to worry about as it has extremely low lease expirations for the next 10 years.
Moreover, their balance sheet is strong with an adjusted net debt / EBITDA of 5.1x, at the low-end of management's target of 5-5.6x and importantly, near term-maturities are low, meaning no interest rate surprises.
With regards to future growth, management has stated the following:
Over the next couple of years, given our low dividend payout ratio and modest debt maturities, we believe we can use excess cash flow, disposition proceeds, and some of our line capacity to increase investments a modest amount and still grow FFOs adjusted per share, excluding the impact from cash basis deferral collections, by around 4% each year,
Valuation
The low payout ratio that management is referring to stands at 63%. That's quite a bit below the standard 75% seen for other net lease REITs, including the likes of Realty Income ( O ) or Agree Realty Corporation ( ADC ). With a yield of 7%, the dividend is an important part of the investment thesis and I find it quite reassuring that it's entirely covered by the experiential portfolio, excluding movie theatres.
In term of valuation, short-term price action will continue to be driven by interest rate expectation, in particular the 2-year treasury yield. Last week we saw this first hand as the 2-year yield dropped by 25 bps on Jerome Powell's decision not to raise rates and in response REITs rallied hard. Over the medium to long-term, I expect price to be driven by 10-year yields and re-pricing as the market realizes that EPR isn't under an existential threat anymore.
Currently, the stock trades at an implied cap rate of 8.4%, while the 10-year yield stands at 4.7%, that's a spread of 3.7%.
My (conservative) base case is that the 10-year yield will fall to at least 4% by the end of 2025 and that spread will decline to 3% as rent coverage improves. These assumptions, along with 4% FFO growth which management has guided towards, yield a 51% upside on top of 14% in dividends receiver over the two years.
A bear scenario, which assumes that FFO drops by 10% , still yields positive upside of 13%, if my yield forecast materializes. Of course, I don't know what will happen to rates. But what's nice about these sensitivity tables is that you can use your own assumptions for the 10-year and the spread and see if the investment makes sense for you. For example, if you think that the 10-year will be at 5% in 2025 and EPR will continue to trade 3.5% above 10-year yields, then you can expect total upside of about 11.7%.
Note: please let me know if you like this kind of sensitivity tables in the comments below so that I know whether to include them next time. They're time consuming to make, but I believe they make it easier to visualize the possible scenarios.
A 7% dividend on top of material potential upside makes EPR a "no-brainer" buy in my view, unless you expect movie theatres to go out of business completely or expect interest rates to rise well above current levels. I expect neither.
The commons are therefore likely a good investment, but Series C preferred shares offer an even more appealing risk-reward. This is because the series includes a conversion option at a ratio of 0.424x.
Today the preferred shares trade at $20.50 per share which corresponds to a conversion price of $48 per share. Since EPR common shares trade at $46.70, which is almost at the conversion price, the upside of preferred shares is now effectively tied to the upside in native shares. Consequently, Series C preferred shares have the same upside as native shares, pay the same 7% dividend yield, but provide more safety thanks to a higher ranking in the capital structure. This makes the Series C even more interesting than the commons. Note that Series E is not as interesting, because its conversion price is much higher and consequently its upside is not as closely tied to the common shares.
For further details see:
EPR Properties: It's Best To Invest Through Preferred Shares