2023-10-03 07:02:00 ET
Summary
- Piedmont Office Realty Trust is an undervalued office REIT with a yield of more than 9% and trading at less than $6/share.
- Despite a dividend cut and reduced outlook, the company is still considered a speculative "buy" due to potential market-beating upside.
- The company is in transition and shifting its business to focus on Sunbelt markets, which presents both risks and opportunities.
This article was produced with Wolf Report.
“People who succeed in the stock market also accept periodic losses, setbacks, and unexpected occurrences. Calamitous drops do not scare them out of the game.” Peter Lynch
Piedmont Office ( PDM ) is a company we’ve been covering for some time, and we even have a small (speculative) stake.
The underperformance here has been significant but in line with the decline for most office REITs, leaving the REIT with a yield of more than 9% and trading at less than $6/share.
Our latest article for the company was around early May of this year, and since that time we've seen a dividend-inclusive decline of around 8% for the stock in about five months.
Not the greatest result, to be sure - but in this article, we will argue why, despite both a dividend cut and reduced outlook, we still consider the company a speculative "buy."
Now to be clear - this is not for everyone.
But as we've shown you in articles before - dividend cuts do not mean that we sell our stakes. In fact, dividend cutters are companies specifically looked at .
Why?
Because in the case of fundamental strength and reversal, these are areas where you may find significant, market-beating upside. If you're willing to take the risk, at least.
We’re well aware that the overall statistics very clearly show that investing in companies that do not cut dividends is statistically, and on a broad basis, better than investing in companies that do.
But that's just it - it's very broad-based.
Some of our best investments we’ve made have come from turnarounds and companies that went to zero dividends for some time (i.e. LADR in 2020).
This does not faze me. We focus on fundamentals and the longer-term outcome. As long as we see that as favorable, we’re still "in."
That being said - know your risk parameters and don't simply follow an article like this.
Realize that we manage portfolios of large size, and a position like this, given its size, is very small to me, both size- and risk-wise.
Let's look at what we have here.
Piedmont Office - Looking at Fundamentals
A dividend cut is obviously never anything positive or close to positive.
The admission of a company that they’ve planned poorly, or that things have changed to the degree where such a change is necessary must be seen as a negative.
As we do here.
The difference we make from other investors is that we don't see it as an automatic deal breaker.
It can be - but in those cases, it's based on fundamentals and the mid- to long-term thesis, not just as a product of that cut.
So, Piedmont.
Offices in seven major markets across the nation.
The company owns 51 assets with a combined square footage of around 16.7M square feet, that's currently around 87% leased - which is low compared to most of our other, higher-rated, and more expensive office REITs.
It also remains a very conservatively sized little REIT.
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After the recent drop, its market cap is less than a billion dollars. The dividend cut means that we have over a 9% yield, and we wouldn't expect, based on current FFO for that to decline even further.
One of the major risks, apart from the obvious sector risks in office, is that Piedmont is shifting its business in the midst of this environment.
PDM is a company that's still in transition, with a year-end 2023 target of being at least 70% annualized Rental Revenue from Sunbelt markets.
This is obviously a good target, but this is a downright horrible time to be a seller of assets.
When interest rates are high and volatility is high as it is now, what you want is to be capital-heavy and safe, in a position to buy, not to sell assets.
That's when deals can be made.
PDM IR
But there's a flaw in bear reasoning for this company and office in general.
The company's post-pandemic leasing spread trends and rent trends are actually very good.
WALT is up, and most of the company's vacancies are Sunbelt-focused, which obviously does not have the same negative trends we see in other parts of the nation.
Piedmont has been through and continues to dispose of unattractive assets.
The problem in doing so in this market is that they’re doing so at less favorable cap rates than before - so thankfully the disposition rate in terms of square footage has been tapering off somewhat since 2021 (Source: PDM).
The future investment strategy focuses on quality, not quantity.
PDM IR
To the more interesting points, PDM also owns a land bank with an additional 3 million square feet that it can use for a variety of things, with land in attractive areas like Orlando, Dallas, and Atlanta.
And while the company is not a market leader in market capitalization or any size-related metric or vertical integration/efficiency, the company does have some of the most appealing REIT-specific metrics in the entire sector.
PDM IR
PDM definitely overextended its payout.
This was a mistake, and PDM is now paying for that with a significantly reduced dividend and a share price collapse which, in our view, is fully justified.
But the arguments made against Piedmont should be based not on its fundamentals but on these momentary trends and the risk for further decline. Because fundamentally, this company has a lot going for it.
And the decline we've seen in the share price is in no way justified by what we're seeing in earnings.
Let’s clear this up.
PDM Valuation (FAST Graphs)
Following a double-digit FFO decline this year, as well as a potential one next year, the company is trading at 3x P/FFO, compared to a premium of 11-13x for the past 10 years.
While punishing the company for its failures through discounting is valid, this degree of discounting is not, as we see it.
That's what we'll focus on in company valuation.
Here's the latest portfolio mix both in terms of market and in terms of industry. You'll find an appealing mix from both perspectives, with much of the "shift" ongoing.
PDM IR
And as you can see, the company really has very low exposure to anything co-working or tech - it's mostly services, engineering/other, legal, and government.
We continue to strongly believe that PDM, for the most part, knows what it’s doing. Management is capable here - far from novices in the field.
It's also one of the lowest-indebted office players, which is why, despite a low market cap, it warrants BBB.
Net debt is 38.2% to gross assets, with a weighted interest rate of 5.5%.
Nothing to panic over.
The risks we see are related to forward growth - not to fundamentals.
We know future growth will be slow or none at all - maybe even a near-term decline. But this is weighted up by the company's bottom-feeding valuation, which is even deeper than before.
Aside from the fact that we have very little information on tenants, which is a risk we covered in our last article, we believe the market has accounted for and even over-discounted for these risks.
Let's look at the upside.
Piedmont Upside in Valuation - Triple Digits
Obviously, there's a significant amount of upside in Piedmont at this juncture.
Based on the current valuation, Piedmont could decline in FFO, and trade only at a 4.8x P/FFO and still get 26% RoR annualized, or 68% in 2-3 years.
Piedmont Upside (FAST Graphs)
The entire office sector is currently so very undervalued that we're seeing assets and companies being valued like dirt for what amounts to a low-single digit FFO decline.
It’s my firm conviction that, in four to five years, investors will be regretting not going into sectors today that are currently viewed as "risky."
This includes healthcare REITs, but it also includes Office REITs.
REITs are a strange sort of investment at times.
When they're out of favor due to interest rates or macro risks, investors tend to be very opposed to investing in them and taking on that sort of investment in their portfolio, even if long term that's exactly when you should invest in them.
Instead, interest spikes when they trade at high valuations with low yields, but then because interest rates themselves are low.
Investors would rather buy Realty Income ( O ) when it yields 3%-4% when interest rates are 1%-2%, than they would when it yields 6.2% with interest rates at 4%-5%, but with O having an upside almost in the triple digits in addition to the yield.
This makes absolutely no sense.
The same is true for office REITs.
Yes, there are office REITs with risks, and the growth rates will likely be sub-par to what we've seen previously.
Yes, vacancies will rise.
But will Piedmont go bankrupt?
Will they no longer be able to find tenants for their buildings?
Will they have to stop paying dividends altogether?
If you believe these things, you're not giving these companies or the capable management teams, or the areas where they work, any sort of benefit of doubt , and this is something we view as extremely flawed.
We won't forecast Piedmont at 12-14x P/FFO here, not when the company is set to decline its NOI for the next few years.
2025E is the earliest we believe we'll see stabilization.
Instead, it's all about finding that bottom.
We believe it would be hard for the company, post the dividend cut, to decline much more.
We would consider 8-10x P/FFO to be a fair upside to a reversal. At ~10x P/FFO, this is what you get.
PDM Upside (FAST Graphs)
Over 200% RoR in a very short timeframe if we see a retracing.
Likely?
No, we don't think so.
Possible over a longer period of time?
Most definitely, as we see it.
"But Wolf Report, this is an unsafe Office player, with less than $700M market cap, and no one knows where it's going!"
Oh really?
Would an "unsafe office REIT" have such good forecasts that analysts are spot on 100% of the time for the past 10 years?
PDM Forecast Accuracy (FAST Graphs)
That's not what an "unsafe office REIT" looks like to us.
This is the sort of stalwart, albeit a small one, that's worth your time.
If your risk tolerance is suitable, then this is worth your money.
Will Piedmont be a company that goes up 200% in six months?
No, we would actually wager money on that it won't.
But over the long term, we believe investors and this company are going to be just fine.
You need to understand that when we invest, we literally do not care one bit about what happens (negatively speaking) to a company in the short term.
All it would make me do is buy more unless fundamentals break.
And that's very rare.
We believe this company is one of the most undervalued REITs we have in our coverage spectrum.
We give the REIT the following thesis at this time.
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Thesis
- Piedmont Office Realty Trust is one of the most undervalued office REITs we cover. It's also investment graded and with a yield that by all appearances is covered.
- Risks do exist - we don't like that tenant information is so sparse - but those risks are weighed up by the fact that the company trades at less than 4x P/FFO at this time. With the fundamentals we do see on the company here, we view this as an attractive prospect.
- For that reason, we view PDM as a spec "Buy." We give the company a PT of at least $9/share
Remember, we’re all about:
1. Buying undervalued - even if that undervaluation is slight, and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.
2. If the company goes well beyond normalization and goes into overvaluation, we harvest gains and rotate my position into other undervalued stocks, repeating No. 1.
3. If the company doesn't go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, we buy more as time allows.
4. We reinvest proceeds from dividends, savings from work, or other cash inflows as specified in No. 1.
Here are our criteria and how the company fulfills them ( italicized ).
- This company is overall qualitative.
- This company is fundamentally safe/conservative and well-run.
- This company pays a well-covered dividend.
- This company is currently cheap.
- This company has a realistic upside based on earnings growth or multiple expansion/reversion.
As always, thank you for reading and for the opportunity to be of service.
Brad and Wolf.
For further details see:
Piedmont Office: Calamitous Drops Don't Scare Us Out Of The Game