2023-08-04 03:02:53 ET
Summary
- Slate Grocery REIT has registered yet another strong quarterly performance confirming the resiliency and continued growth potential of its business (properties).
- SRRTF managed to improve its occupancy ratio, increase FFO and strengthen the interest rate coverage aspect.
- SRRTF delivered a record leasing activity, where the leasing spreads remained close to double digits and were significantly higher for the non-renewal option leases.
- Despite the improving performance and proven resiliency, the P/FFO discount has steepened to ~56%. Even the Management team has initiated an active buyback program.
- In a nutshell, post Q2 results, the bull story has become even more attractive, which if played is rewarded by a juicy ~8.9% dividend.
Roughly three months ago I covered Slate Grocery REIT (SRRTF) here in Seeking Alpha indicating a buy rating . The underlying thesis was that the market is assigning too high of a risk premium on SRRTF that is unjustified in the context of cash flow dynamics and growth prospects.
The market seems to dislike SRRTF's slightly higher leverage ratio compared to direct peers and the fact that a significant chunk of leases expires over the next 2-3 year period right when the recessionary risks are high.
However, my analysis shows that while the debt is relatively high compared to the comparable REITs, on an absolute level the leverage ratio of ~49% is completely safe considering that there is tiny spread between SRRTF's average interest cost (4.1%) and the market level interest rate.
In other words, the suffering from elevated interest costs has to a large extent already been backed into the current FFO figures. Plus, positive organic growth and juicy leasing spreads help further mitigate any risks/concerns stemming from the existing leverage.
In addition, I find that a ~35% discount relative to SRRTF's peers operating in the retail equity REIT space ("free standing" segment) lacks substantial basis since the underlaying cash flows show superb resiliency and continued like-for-like growth.
Now SRRTF has circulated Q2, 2023 results, which one the one hand confirm my thesis points pertaining to the resiliency and continued growth and from the other hand reveal additional insights, which render the buy thesis even more attractive.
Synthesis of Q2 earnings
Let's start with the basics that will also reinforce the bull argumentation around resiliency and continued growth.
Looking at the key operational and leverage metrics, we can see how SRRTF has been firing on all cylinders (the following information is expressed on a quarter-to-quarter basis):
- Total occupancy ratio rose by 20 basis points reaching a solid 93.9% level.
- Due to lease renewals and new tenants entering SRRTF's space, the portfolio weighted average lease term improved by 0.2 years landing at 4.7 years.
- Like-for-like NOI grew by 1.1%, whereas thanks to cost optimization the FFO figure increased by 3.4%. As a result, the quarterly FFO payout ratio decreased to 79.3%.
- Despite the unfavorable interest rate environment and tight lending conditions, the interest coverage ratio actually went up to 3.03x translating to a ~6% improvement in the rate of change terms.
So the facts clearly prove that SRRTF is stable and growing business.
Unfortunately (or fortunately for long-term investors), the prevailing valuation of SRRTF implies a different picture.
If we annualize the most recent quarterly FFO figure and contextualize that with the current price of SRRTF stock, we arrive at a P/FFO of 8.8x. When I initially issued my buy article on SRRTF, the P/FFO stood at 9.2x. Consequently, the valuation divergence between SRRTF and the peer group has steepened to ~56%.
Against the backdrop of the aforementioned dynamics, the equity story is getting really interesting.
Now, once we have the baseline clear, let me introduce three additional facts stemming from Q2, 2023 data, which, in my humble opinion, further increase the odds of gradual convergence to the average of peer multiples.
First , in the Q2, 2023, SRRTF registered a record 1.0 million square feet of total leasing, which explains ~8% of the total portfolio. Typically, lease renegotiations at such a magnitude tend to increase the risk of suffering from either depressed spreads or increased vacancies. However, in SRRTF's case the results were positive across the board. Namely, the Management captured 7.1% spread to average in-place rents without any negative correction on the occupancy front. This clearly confirms the structural demand for SRRTF properties and sends a strong message that the gap between in place rents and the market average rents should eventually close.
Second , if we peel back the onion a bit, the data on the non-option renewal spreads indicate an even better picture. The non-option renewal spreads were 10.9% above average in place rents. Plus an additional 140,000 square feet of new leasing was signed at a 23.7% spread. What this essentially tells us is that there is a considerable potential for SRRTF to organically grow the like-for-like NOI in a relatively considerable manner.
Third , the weighted average cost of interest rate decreased by 16 basis points on a quarter-to-quarter basis. In Q2, SRRTF stipulated a $175.0 million pay-fixed receive-float interest rate swap as well as revised the existing $137.5 million interest rate swap in order to neutralize the variable rate. As a result, SRRTF managed to fix 96.6% of the outstanding debt. This in combination with no maturities in 2023 puts the Company in a very solid position to either optimize its balance sheet or seek accretive growth opportunities.
Bottom line
After looking into the Q2, 2023 earnings the entire bull thesis for SRRTF has become more attractive. This is both from the valuation and underlying performance perspective. While SRRTF has virtually improved all of the metrics during Q2 and through its leasing activity proved that there is a huge embedded potential for an organic growth via higher in place rents, the market has totally ignored this by putting even higher discount to SRRTF's stock.
Plus, during Q2 SRRTF imitated share buybacks, repurchasing 0.6 million units in the quarter at a weighted average price of $9.65. Again, this, in my opinion, shows that the Company also thinks that the discount between the market price and the embedded value is just too wide.
Going forward, I expect SRRTF's share price to slowly but surely tick upwards both due to the multiple convergence and stronger earnings. While waiting for this to play out, investors are being rewarded with a very juicy dividend of 8.9%.
Risks to the thesis
Granted, we have to also appreciate the risks associated with this thesis. For example, despite these remarkable results the stock has traded sideways and underperformed the broader REIT market since the date when I published my article in May. So, I think that there are two important risk factors we should consider here:
- Flat share price irrespective of the positive momentum in the underlying performance. As described above, the market seems to ignore the positive dynamics on the fundamental level within SRRTF. It is hard to explain concretely what might be the reasons, but my 'high-probability' guess would be the small-cap factor, which leaves SRRTF out of major indices, and the fact that headquarters are based in Canada, which, in turn, excludes SRRTF from NAREIT classification. Yet, honestly, I do not mind that the market does not value the Stock appropriately since the current dividend yield of ~9% is extremely attractive and stable making the 'convergence process' acceptable.
- Relatively high indebtedness, which limits SRRTF's flexibility to make accretive investments going forward. As of now, SRRTF has a leverage ratio of ~50%, which is one of the highest in the sector. Looking at the most recent quarters, we can see that there has been no M&A activity despite rising cap rates in the market. However, I believe that this is not an issue; and there are two reasons for that. (1) SRRTF has a clear embedded internal value in the portfolio that is confirmed by the recent leasing performance. Namely, SRRTF has a lot of room for an internal growth (organic) growth just from resigning expiring leases with prices that closer reflect the prevailing market levels. (2) The current state of the balance sheet is strong, where as indicated above, the well-structured debt maturities with almost completely neutralized variable rate risk put the Company in a nice position to optimize the balance sheet before major maturities kick-in in 2025/2026.
For further details see:
Slate Grocery REIT: Q2 Results Further Strengthen My Buy Thesis