2023-07-18 15:40:40 ET
Summary
- Leading industrial-operator, Prologis, reported Q2 results that surpassed expectations.
- Despite an expected moderation in the rental rate environment, results suggest PLD remains securely fastened in the driver's seat.
- Though shares have gained over the past year, the stock is still underperforming broader markets.
- This appears disconnected, given the company's strong operating results.
- I view shares positively following the earnings release and see upside potential of about 10% from current trading levels.
Pricing power is a coveted luxury and one that industrial operators may not keep forever. Fresh results, however, from sector bellwether, Prologis ( PLD ), show that it may be kept for longer than most expect.
PLD Q2 Results
Any threat of an industrial slowdown hasn’t yet impacted PLD’s portfolio. At period end , average occupancy ticked down slightly to 97.5% from 98% in Q1. Despite the decline, occupancy still stands above the projected year-end occupancy rate, which is expected to be 97.25% at the midpoint.
Though occupancy levels dropped in Southern California, PLD’s largest operating market, occupancy held at a healthy 97%. This is notable since this market was referenced in a recent short report by Hedgeye analyst, Rob Simone. While the short report was on Rexford ( REXR ) and not on PLD, which was seen more favorably, the report still cautioned that rental rate growth in the region would slow.
PLD, however, showed that they very much remain in the driver’s seat on rental rates. In Q2, PLD realized cash rent spreads on new and renewed signings of 48%. This follows spreads of 42% in Q1, which were, itself, a record high. This contributed to growth in same-store cash NOI of 10.7%, a continuation of the double-digit growth logged in Q1.
Market Reaction To PLD’s Q2 Earnings
Shares rose slightly in pre-market trading on Tuesday immediately following their release, bringing their YTD gain to about 14%. This outperforms the broader industrial REIT sub-sector and the overall FTSE NAREIT Equity REITs index, which are up about 9% and 5.5%, respectively.
But the performance lags the S&P ( SPY ), which is up over 17.5% YTD. The underperformance is more pronounced on a 1-YR timeframe, where the S&P has provided investors with a return nearly double that of PLD.
And since a prior update on the stock, where I maintained my bullish view, the S&P has gained about 10% versus just under 4% by PLD.
Key Takeaways Of Prologis’ Q2 Results
Positive Revisions To Full-Year Guidance : PLD turned in a strong beat on their Q2 release. Quarterly core funds from operations ("FFO") came in at $1.83/share, $0.16/share above expectations. Record rental rate growth and continued strength at the property level were two contributing factors for the beat.
While guidance was largely left intact elsewhere, PLD increased their outlook for same-store cash net operating income ("NOI") by 37.5 basis points at the midpoint. Growth is now expected to be 9.75% at the midpoint from 9.375% previously.
The stronger same-store outlook corresponded to a 2.2% increase to the midpoint of full-year core FFO expectations. This is now expected at $5.58/share. At current trading levels, this would indicate a forward share price multiple of just under 24x.
Continued Normalization In U.S. Space Utilization : Declining utilization rates may be indicative of rising “shadow space”, or space that is considered among the first to go vacant upon any downturn in the economy. While PLD did report a decline in Q1, this was seen more as normalization than anything of concern. I view Q2’s flat reading as supporting evidence. And looking ahead, I expect utilization to stay within historical averages.
Decline In Lease Proposals And Retention Levels : Though PLD commenced over 40 MSF of leases during the quarter, activity appeared more muted compared to prior periods. Commencements were about 6 MSF lower than in Q1. And notably, proposals took a turn lower below historical averages. This could be due to the general slowdown in activity in the overall sector.
This was also accompanied with a steeper drop in retention to 70.5% from 77.2% in Q1 and 78.6% in the same period last year. While this is offset by PLD's pricing power, the decline in activity, occupancy levels, and retention rates suggest rate growth may be at or near a peak.
Is PLD Stock A Buy, Sell, Or Hold?
Though shares in PLD have gained in 2023, the gains pale in comparison to their portfolio results. The company is still recognizing rent spreads in the neighborhood of 50% and is reporting double-digit increases to same-store NOI. Yet the stock is up less than 15% YTD and less than 10% over the past year. Based on the muted response following PLD’s earnings release, a course correction in the share price doesn’t appear to be in the works just yet.
This is perhaps due to outstanding concerns regarding an eventual slowdown in rental rate growth. Cushman & Wakefield’s ( CWK ) Q2 quarterly industrial report , for example, showed that the national vacancy rate rose to 4.1% from 3.6% in Q1. Gross new leasing activity was also reported to be down 8.9% from last quarter. And looking ahead, CWK expects construction completions to outpace demand throughout the second half of 2023 and 2024, resulting in an increase in vacancy levels to the 5% mark.
While the rise in the vacancy rate to above 4% is notable since it was the first time it reached this mark since mid-year 2021, it’s important to also note that the rate is still below the 10-year average of 5.2%. Likewise, even with an expected uptick to 5% in 2024, the rate would still trail the 15-year average of 6.6%.
For their part, PLD is operating at healthy occupancy levels, with utilization and retention levels in-line with historical averages, despite a recent pullback in the latter. The vacancy threat, therefore, is perceived as low. And despite the fears pertaining to rental rate growth, rents are still expected to cross $10 PSF in 2014, according to CWK’s quarterly industrial report. If this occurs, it would be a new milestone for average rents.
While rate growth will, nevertheless, likely moderate, the industry is expected to benefit from a slowdown in the future pipeline due to an accelerating pullback by smaller developers on new projects. This could reaccelerate rents in later periods. In the meantime, high occupancy and low vacancy levels provides a formidable floor to any pullback.
In my view, PLD can support a price of $140/share by ending the year with year-end occupancy at or above the top end of their guidance range, while also preserving key portfolio metrics, such as utilization and retention, at current levels.
While the best of times for industrials may have passed, the times are still better than markets are giving them credit for.
For further details see:
Prologis: Continuing To Flex Its Pricing Power