2023-10-17 05:01:52 ET
Summary
- NewLake Capital Partners is a net lease real estate investment trust focused on cannabis cultivation properties.
- NLCP pays an attractive 12% dividend yield and has a net cash balance sheet.
- The stock trades at a significant discount to net lease REIT peers and has the potential for a sharp re-rating higher.
- I explain why the stock is priced attractively even under very bearish scenarios - NLCP is one of my top picks in the market today.
There is no shortage of high-yielding investments in this higher interest rate environment. But these stocks tend to be faced with interest rate headwinds, especially from having to refinance debt maturities at higher rates. But not all stocks have the same risks. NewLake Capital Partners ( NLCP ) is a net lease real estate investment trust (‘NNN REIT’) focused on cannabis properties. The illegality of cannabis at the federal level has meant that its cannabis operator tenants are subject to unusually high corporate tax rates and debt interest rates. Throw in some price compression and Wall Street’s once-optimistic view of the cannabis growth story has turned sour. The pessimism is in my view overdone, at least in the case of NLCP. NLCP pays a dividend yield of 12% while having the unusual characteristic of possessing a net cash balance sheet. The stock looks undervalued even assuming extremely bearish scenarios and there is clear justification for a sharp re-rating higher. I rate NLCP a strong buy as a true asymmetric opportunity for both value and growth investors.
Investment Thesis
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NLCP pays an attractive 12% dividend yield.
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The company has a recurring revenue model backed by net leases. Net lease REITs typically trade at premium valuations.
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The higher risk profile of its cannabis tenants is offset by the higher acquisition yields (averaging over 12%) and annual lease escalators (which average around 2.7%).
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The company has a net cash balance sheet, in contrast with net lease peers which typically have leverage ratios in excess of 5x debt to EBITDA.
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The company has completed a $10 million share repurchase program and has authorized a new program - management is actively taking advantage of the undervalued stock price.
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Re-scheduling of cannabis would be a key catalyst, but I see other avenues for improving tenant credit metrics even if legislative reform does not take place.
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The stock trades at a large discount to net lease REIT peers, even before accounting for the stronger balance sheet and growth prospects.
Business Model
NLCP is the second largest publicly traded cannabis REIT behind the more well-known name Innovative Industrial Properties ( IIPR ). Like IIPR, NLCP uses triple net leases which means that the tenant is accountable for real estate taxes, insurances, and maintenance capital expenditures. Dividend investors may recognize that term because it is the same model used by popular stocks Realty Income ( O ) and W. P. Carey ( WPC ). In contrast with IIPR, NLCP has focused mainly on acquiring cannabis cultivation properties in limited license states with a similar star-studded tenant roster featuring names like Curaleaf ( CURLF ), Trulieve ( TCNNF ), and Cresco Labs ( CRLBF ).
The vast majority of their properties are operated by tenants who have vertical operations within the state. Vertical operations mean that its tenants have full control from seed to sale - this has typically led to stronger EBITDA margins. While cannabis properties are widely seen as among the highest risk in the net lease sector, it is worth noting that the estimated four-wall coverage of cannabis properties is materially higher than the sector.
In its most recent quarter, NLCP delivered 8.6% YOY revenue growth in spite of rent collection coming in at just 92% (I have confirmed with management that GAAP revenues are accounted for on a cash basis). NLCP delivered FFO per share of $0.44, representing 47% YOY growth. That, however, came only slightly higher sequentially than the $0.43 per share number shown in the prior quarter. With the company’s cost of capital (equity valuation) remaining at high levels, sequential growth has primarily come from the 2.7% annual lease escalators. I should note that most REITs would kill for that 2.3% sequential growth rate given that high interest rates have been presenting significant headwinds for the broader REIT sector, especially from higher interest rates on floating-rate debt and refinancing debt maturities.
Those headwinds have not appeared for NLCP as the company ended the quarter with $41 million in cash and just $2 million in debt (that compares favorably against the $280 million market cap). The strong balance sheet enabled NLCP to repurchase 105,679 shares for $12.62 each in the quarter, totaling $1.3 million. NLCP also has $89 million available under their credit facility which would bear a fixed rate of 5.65% for the first three years. I note that subsequent to the end of the quarter, the company announced that it had almost completed its $10 million share repurchase program and had authorized a new $10 million program .
Management has given AFFO guidance for the full year of $39.8 to $40.8 million, representing 4.1% YOY growth. The company generated $1.84 in annualized AFFO per share in this past quarter, comfortably covering the $1.56 per share annualized dividend. I reiterate that its tenants are responsible for recurring CapEx spend, meaning that AFFO closely matches free cash flow available for the dividend (unlike other REITs which may have significant maintenance CapEx).
Why Is The Stock Trading So Cheaply?
Whenever a stock has a yield so high, investors must always ask the critical question: what are we missing? The high present yield might be understating the pessimism - peer IIPR previously traded at nosebleed valuations at under 2% in years past.
Seeking Alpha
The answer is twofold. First, the stocks of US cannabis operators have been completely destroyed over the past few years, even after accounting for the year-to-date rally.
Next, as hinted earlier, US cannabis operators pay above-average corporate tax rates and debt interest rates. We can see below that one of the top operators, Curaleaf - the most significant tenant of NLCP - generates respectable 20% adjusted EBITDA margins.
2023 Q2 Press Release
However, the company generated negative operating income in its latest quarter but still recorded $41.4 million in income tax expense. US cannabis operators are unable to deduct operating expenses from the calculation of taxable income, meaning that they are effectively paying income taxes based on gross profits.
2023 Q2 Press Release
While CURLF (and many other operators) is still generating positive cash flow even after accounting for the higher tax and debt interest rates, the fact that NLCP has over 4x 4-wall coverage is not an apples-to-apples comparison to the 2.5x coverage at traditional net leases due to the lower conversion of EBITDA to free cash flow.
NLCP also has some troubled tenants. On the conference call , management noted that Massachusetts tenant Revolutionary Clinics (making up 9.9% of rent) did not pay rent. NLCP applied 25% of Revolutionary Clinics’ security deposit toward second quarter rent. Management again discussed why they are continuing to work with this tenant, stating that the tenant previously had cultivation issues and faced delays in opening 2 adult-use stores. They have recently opened 2 new adult-use stores in Somerville and Leominster all while improving their cost structure. There’s reason to hope for a full recovery here, and I emphasize that it is entirely within NLCP’s rights to take back possession of the property if they wish to (in addition to seeking damage recoveries, as they already own the property).
Management also discussed the status of their troubled Pennsylvania tenant in Calypso. While Calypso continues to pay rent in full on a weekly basis, management noted that they have been “working on a sale for quite some time now.” Management expects the sales process to complete by the end of the third quarter.
Cannabis operators have been facing pricing pressures that have simultaneously stunted growth rates and compressed profit margins. That has led to an evaporation of enthusiasm for the sector, as investors began focusing more on the poor current profitability metrics and believing less in a more profitable future (due to, as discussed above, normalized debt and tax rates). Between the plunging stock prices and the low free cash flow generation of the tenants, it is easy to see why NLCP has traded down to such pessimistic levels.
Valuation and Price Target
The closest peer is IIPR. IIPR was recently trading at a 9.5% dividend yield, 9.24x FFO, and 9.9x EV to EBITDA. NLCP recently traded hands at a 12.1% dividend yield, 7x FFO, and 6.2x EV to EBITDA. At a 9.5% dividend yield, NLCP would trade at $16.40 per share, offering a 24% potential upside to this closest peer (in addition to the 12% dividend yield).
An argument could be made, however, that cannabis REITs overall trade at an undeserving discount to traditional net lease REITs. O recently traded hands at a 6.1% dividend yield, 12.7x FFO, and 17x EBITDA. SRC recently traded hands at a 7.9% yield, 9.3x FFO, and 13x EBITDA. At an 8% dividend yield, NLCP would still trade at a large discount to SRC on an EV/EBITDA basis (it would trade at around 9.5x EV/EBITDA) due to the net cash balance sheet, but at $19.50 per share, the stock would offer 47% potential upside (again, in addition to the 12% yield). If NLCP were to trade in line with Realty Income on a dividend yield basis, which can be potentially justified due to the higher lease escalators and net cash balance sheet, then the stock would trade at around $25.60 per share, offering 94% potential upside (in addition to the 12% yield).
Margin of Safety
The real crux of the value proposition comes from the margin of safety. Under a hypothetical liquidation scenario, the downside risk looks quite modest. NLCP recently traded hands at around a $280 million market cap. Yet the company had around $466 million in total assets (excluding depreciation as tenants are paying for maintenance CapEx) after deducting $4 million split between accounts payable and debt. After further excluding $40.7 million in cash, there was around $425 million spread across properties and investments.
2023 Q2 Press Release
If we assume that NLCP sees all of its tenants go bankrupt and give up their properties and that NLCP is forced to liquidate all these investments at a 50% loss, then there would be roughly $213 million in cash left (in addition to $40.7 million in cash). Shareholders would have suffered a 9.2% loss in this scenario. That’s a rather mild loss considering the pessimistic assumptions and ongoing dividend payouts help to further reduce that potential downside.
That's one possible liquidation scenario. What about downside scenarios of a different flavor, where NLCP is somehow "forced" to lower rents? I put rents in quotes because I am doubtful that such a scenario is so reasonable. I note that there is no legal reason why NLCP would have to do so, as net leases can often hold up even in bankruptcy. But even here, NLCP looks attractively valued. In its latest quarter, the company generated $11.4 million in revenue which converted into $9.9 million in AFFO (look at that margin!). Assuming a 50% haircut to rent, AFFO might decline to as low as $4.2 million. NLCP would be trading at around 17x that number. The aforementioned Realty Income has historically traded around that number but has recently traded at around 13x FFO. A real argument can be made that NLCP deserves to trade at a premium due to the net cash balance sheet and the higher annual lease escalators (2.7% versus 1% at Realty Income). But even if we were to assume that it trades down to 13x FFO, that implies a 22% loss. Again, a rather lukewarm apocalyptic scenario.
If we take into account that NLCP has a net cash balance sheet, then the potential downside there declines further given that O is trading at around 17x EV to EBITDA.
It is rare that you get to invest in a name that pays out a double-digit dividend yield with so much downside support. High-yield names almost always are filled with substantial amounts of debt and substantial downside.
Potential Catalysts
Every year that NLCP pays its dividend, the projected losses decline. Just one year of dividends would more than cover our bases in our base apocalyptic scenario above. Management is going further than that. In September, NLCP announced that it had completed its $10 million share repurchase program at an average price of $12.96 per share and had authorized a new $10 million share repurchase program. That means that the company has already repurchased over 3% of shares outstanding. Demand for sale and leaseback transactions has dried up given the higher interest rate environment, but repurchasing stock at a 12% dividend yield offers a highly competitive investment alternative, and one shareholders should be cheering for.
OK, The Real Catalyst
That said, typically when one thinks of a catalyst, they are hoping for something more exciting. In August of this year, the stocks of US cannabis operators rallied due to news that the US Department of Health and Human Services had sent a letter to the US Drug Enforcement Administration recommending that cannabis be re-scheduled to a Schedule III drug. Such a move would in theory address the egregious corporate income tax rates, which in turn may help to reduce the cost of capital (including debt interest rates). There are also renewed hopes that the Senate might pass some form of SAFE banking , which would protect financial institutions seeking to serve cannabis businesses. I am of the view that NLCP is trading at such distressed valuations mainly due to concerns about their tenant credit quality - these legislative actions would very quickly address such concerns. And while I may be burned for stating as much, the chances of positive reform look as high as ever.
But What If Politicians Drop The Ball?
While it would be nearly unprecedented for the DEA to go against the wishes of the HHS, it is always possible that our government and politicians somehow fail to pass any sort of legislative reform. There is still hope, nonetheless. With NLCP focusing on limited license states, substantially all of its tenants (at least the publicly traded ones with public filings) would be posting solid cash flows in the absence of debt interest expense. If US cannabis operators fall under financial distress, I expect them to dilute equity holders to raise cash and pay down debt. It is always possible that NLCP agrees to reduce rents under such reorganizations, but bankruptcy is not available to these tenants (due to the federal illegality of cannabis) and it is thus my view that diluting equity holders would be the most likely outcome. While such a move is likely to lead to a great downside for the stock price, it would be highly credit-positive for the landlord NLCP.
Risks
The main downside scenario instead occurs if the legal cannabis business model proves unsustainable - perhaps legislators eventually fully legalize cannabis and no one wants to pay for legal cannabis. In this scenario, the cultivation facilities may be worth substantially less. Yet with NLCP having no debt, the downside scenarios are more modest than is implied in the stock price, as shown above. California is one state that has an unlimited license model (and one in which NLCP has minimal exposure to) and legal operators have struggled to generate consistent gross margins in there, with the exception being Glass House Brands ( GLASF ). My naive political judgment tells me that the limited license model may last over the long term due to both the more sustainable business models as well as the fact that public sentiment towards the plant probably cannot change course so quickly. Even in my home state of California, I still notice a deep negative stigma towards cannabis even among millennials.
It is possible that margins continue to compress. It is possible that politicians do not come to the rescue of their legal operators (they can help most by assisting in cracking down on the illicit market). NLCP looks reasonably valued even in the event of having to reduce rent, but I am doubtful the stock delivers reasonable returns if the US cannabis business model proves unsustainable. It is possible that the federal government reverses course and applies further regulatory crackdown on the cannabis sector, perhaps making it so that NLCP is also subject to 280e taxes. I estimate that 280e taxes would reduce AFFO by around 24% (make no mistake, NLCP would still be generating healthy amounts of free cash flow).
On the flip side, it is hard to imagine a world where state governments do not eventually try to assist their legal operators, and I am also doubtful that state governments allow a meaningful increase in new build-outs for cultivation facilities (neighborhoods often complain about the smell). While the financials of the tenant cannabis operators might not look pretty, high leverage is arguably the biggest driver of the poor free cash flow conversion. Many of the multi-state operators (‘MSOs’) had taken on high amounts of leverage in order to expand their footprints. While the path between here and there won’t be pretty, I expect almost all of these operators to undergo deep equity raises in order to reduce leverage and the associated interest expenses.
Finally, while I have painted a rather pessimistic view of the financials of the tenants, recent financial results have offered glimmers of hope - these names are starting to show stabilizing margins and stronger growth rates as they lap easier comparables. It is possible, if not likely, that at some point they return to taking market share from the illicit market, eventually helping to offset ongoing price compression.
Conclusion
NLCP is priced like a dividend cut is likely, but the stock looks attractively valued even assuming very bearish scenarios. Its tenants have a poor conversion of EBITDA to free cash flow, but that is in large part due to artificially high corporate tax and debt interest rates, as well as high leverage loads overall. A re-scheduling of cannabis to Schedule III by the DEA could go a long way in addressing those headwinds, as well as the passage of SAFE banking in the Senate. There also remains the possibility that the tenants (at least the publicly traded ones, which make up over 70% of overall rent, improve their balance sheets through raising equity. NLCP has a net cash balance sheet which helps to cushion equity holders in downside scenarios. The stock trades at an attractive 12% dividend yield with substantial upside to trade in line with traditional net lease REIT peers. I reiterate my strong buy rating for the stock in spite of the murky near-term outlook.
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My Top Pick: NewLake Capital Yields 12% With Net Cash Balance Sheet And Built-In Growth