Summary
- I like to buy companies with sound fundamentals that are cheap enough to a point where I can reasonably expect to outperform the market as the valuation normalizes.
- Prologis has proven that it can deliver great results and grow its portfolio. It also has hands down the best balance sheet I've seen in the REIT sector.
- Unfortunately, it is too expensive as I only expect it to return 8% annually over the next three years.
- If you're like me and want alpha, check out my strategy in the article.
Dear readers/followers,
I recently published an article on STAG Industrial (STAG), where I argued that the industrial REIT sector is well positioned to grow as e-commerce is expected to reach 30% of all retail sales by 2030 (up from 14.5% today). In the case of STAG, however, the market seems to have got ahead of itself making the company overvalued. I have firm rules in my investing strategy and one of them is that I don't buy a company, which I believe is overvalued, not even if it has good growth prospects. The reason for this is simple - I want to generate returns superior to those of the market and believe the best (and perhaps only) way to do that is to rotate from overvalued companies/sectors into undervalued ones. Valuation is of course subjective, but if we can successfully identify under/over-valued companies, this strategy should generate a significant alpha over time.
In today's article I want to analyze another industrial REIT - Prologis ( PLD ), which seems very well positioned to benefit from the tailwinds facing the industrial REIT sector and shows promising growth prospects. The question is whether we can buy it cheaply enough to a point where we can realistically expect superior returns.
How do I generate alpha?
As new contributor to Seeking Alpha I realize it's important to provide more context for my analysis so that you can understand not only how but also why I make my investment decisions. Below I include a short summary on how I like to manage my active stock portfolio.
- Start with a thesis why a given industry/sector should outperform
- Stay overweight in those sectors for as long as the thesis is valid
- Look for companies with sound fundamentals that are either undervalued or fairly valued with exceptional growth prospects
- If a company becomes overvalued, trim the position and rotate into another stock/sector that is still undervalued
- If a company becomes increasingly undervalued and the thesis is still valid, add to the position
- Generate alpha and repeat
My total return then comes from the dividend yield, EPS growth and multiple expansion as the valuation normalizes over time. I always target a total return in excess of market returns (>8%) to generate alpha.
What things do I look for when selecting individual stocks to buy?
- Strong and safe fundamentals
- Good management teams with a track-record of caring about shareholders
- Healthy EPS growth
- Well-covered dividend
- Discount relative to peers and/or historical fair multiples
- Other catalysts
Prologis overview
With a market cap of $115 Billion, Prologis is one the large REITs in the world and by far the largest industrial REIT. In fact Prologis's market cap is double the size of all of its peers combined! The company owns a total of 5,495 properties in 19 countries around the world with a total of 1.2 Billion square feet. The portfolio is very heavily concentrated in the US (86% of NOI).
Prologis has a diverse and well diversified mix of tenants. Amazon, being by far their largest tenants accounts for 5.3% of total rent, and no other tenant accounts for more than 2% of total revenue. Most of the tenants can be characterised as B2B or online fulfilment, and the subcategories of goods that are stored within the buildings are quite well diversified as seen below. WAULT (weighted average unexpired lease term) stands at 4.2 years.
Financials
The company has delivered solid results in 2022 . Occupancy has remained stable at 98% and same store NOI has increased by 7.7%. These strong operational results as well portfolio expansion resulted in a 15% YoY increase in net earnings and a 32% YoY increase in Core FFO attributable to shareholders. On a per share basis Core FFO came in at $5.16 compared with $4.15 in 2021. For 2023 the company has guided to a Core FFO of $5.40-$5.50 per share, which would imply a growth of 5.6%.
The company has continued to grow its portfolio in 2022 mainly through development, with $2.9 Billion worth of assets newly stabilized (at an average stabilized cap rate of 6.3%). Acquisitions of $2 Billion (at an average cap rate of 4.3%) have offset disposal of $2.2 Billion (at an average cap rate of 4.0%).
Prologis has a dividend of $3.16 per share translating into a 2.5% dividend yield. This dividend is very well covered with a payout ratio vs Core FFO of just 0.61. Frankly a 2.5% yield is low for any REIT, making PLD more of a growth play - the dividend has grown with a CAGR of 12% over the past years which is significantly above the average dividend growth for industrial REITs and the S&P500 of 8% and 5%, respectively.
PLD has a stellar balance sheet (unlike any other REIT) with an LTV of just 28% and is one of just seven A-rated REITs. It has about $24 Billion of debt at a weighted average interest rate of just 2.5% (vs 10-yr treasury yield of 3.8% and STAG's average rate of 3.29%). 87% of this debt has a fixed interest rate and there no debt maturities due in 2023 and only a small maturity of $400 Million in 2024. With over $4 Billion in available liquidity (of which $300 Million is in cash), the REIT is extremely well capitalized and has a super conservative balance sheet compared to peers.
Valuation
First, let's have a look at valuation on an NAV basis. PLD reports their assets at $87 Billion - of this their operating portfolio accounts for $78 Billion ( page 35 ). With NOI of $4.68 Billion, the operating portfolio is valued at an implied cap rate of 6.0%. I think this is too conservative given the quality of assets that PLD operates and given that all of their acquisition and disposals that took place in 2022 were at cap rates of 4.0-4.3%. Personally I would feel comfortable with a cap rate of 5.0%, which would bring the value of their operating properties to $94 Billion ($16 Billion more than reported). Deducting their debt of $24 Billion we get adjusted NAV of $79 Billion. Compared to their market cap of $115 Billion, this suggests that the company might be overvalued as it is trading above the value of its assets, even after we decreased the cap rate to 5%. In fact if we calculate the implied cap rate that the market is pricing in, we get 3.6%!
Based on a P/FFO multiple, the company is currently trading at 24x FFO. The long-term average since 2012 stands at 22.7x and some would argue that this average should be adjusted upwards because e-commerce hasn't really picked up until 2020 and while that's true I could just as easily argue that because of higher interest rates and the uncertainty around how long they will remain high, we should adjust the average downwards. I think these two effects might end up offsetting each other, making the average quite accurate. In any case, the stock is trading about 5% above the historical average, which isn't enough to really call it overvalued based on the P/FFO multiple comparison. When we look at forward guidance of 5.6% growth in 2023 and assume that this growth continues until 2025, we can calculate that FFO will stand at $6.07 per share in 2025. With a multiple of 24x, this means a PT of $145 per share in 2025.
So what can we reasonably expect from PLD?
- 2.5% dividend yield growing at 5% (yield on cost of 2.9% in 2025)
- EPS growth of 5.6%
- no multiple expansion
- -> total annual return of around 8.3%
To sum up the valuation section, PLD seems fairly valued. Although it is trading at a premium relative to NAV, it is not too far above its average historical P/FFO multiple and can be expected to earn a market return of around 8%.
Takeaway
PLD is a great example that illustrates how I look at investments. It is a great company, one that has proven that it can grow its business, as well as earnings and return wealth to shareholders. It also has a superb balance sheet, frankly unlike any other REIT that I've seen. Unfortunately, it cannot currently be bought at a price where we could reasonably expect to outperform the market, not even with its solid growth guidance and industry tailwinds.
With an expected total return of 8% I could buy the S&P500 and do just as well. For this reason I rate PLD as a " HOLD " here at $125 and would only consider buying the stock if it falls to its October lows around $100.
For further details see:
Prologis: No Alpha Here