Sunday, July 9, 2017

Following Buffett into STOR Capital

In the past few years I watched with confusion as Buffett bought up IBM, Apple, airlines stocks, and just last month a shady Canadian lender called Home Capital Group. There are definitely times I wonder if he's gone senile. But Berkshire's investment in STOR Capital makes a lot of sense and I'm following.

Trading at $22-23 range, STOR Capital (STOR) can offers 20% IRR over the next few years. This comes from mid-teens adjusted funds from operation (AFFO) growth plus dividend yield of ~5%. I assume Price/AFFO multiple stays constant since it’s already a reasonable ~14x.

Thesis Sketch
  • STOR’s sales-leaseback model has a long runway for growth, and the weak retail environment may actually help in that respect. 
  • Berkshire’s involvement strengthens the already solid balance sheet. There’s a possibility that STOR can turn into a platform to consolidate the industry. 
  • Just a well-run company. Prudent leverage levels means this is something I can double down on if stock goes south.

What They Do
STOR Capital buys retail locations from companies and leases back to them at negotiated rates. Unlike typical landlords who start by targeting desired locations then try to minimize vacancy, STOR starts with specific business customers and then figure out the lease terms they need.

In this way STOR is more like a financial service company than purely an asset owner. Another way to view the company is that STOR takes on credit risks of their clients, but that risk is collateralized by revenue generating real-estate.

There are inherent advantages with this business model. First, since these properties come with tenants, occupancy rates are high (~99.5%) and STOR don’t incur much costs to lease out the properties. Second, the leases are “triple-net”, meaning tenants are responsible for not only insurance and taxes, but also property maintenance costs. This means STOR has very little capex needs, so their AFFO is a good proxy for free cash flow. Finally, the customer service component allows STOR to stay away from auction situations, and historically they have been able to buy real estate at below replacement cost.

Growth Prospects

STOR has a track record of dividend growth, backed by mid-teens growth in cash flows. The growth is mostly through acquisition of real estates, which STOR has been investing about $1-1.2bn per year. Keeping up this pace would imply rental revenue growth of ~15% CAGR the next 3 years or so.

I think STOR can continue, if not accelerate, this pace of expansion. In the latest 10K they estimated an acquisition pipeline of $8.6bn at December 2016, compared to $5.2bn worth of properties on balance sheet. Furthermore, the U.S. is in a weak retail environment, and more companies will likely try to offload their real estate and optimize their capital structure. This would create opportunities for STOR to buy at attractive prices.

STOR is also now a strong hand in a weak industry. On 6/26/2017, Berkshire invested some $375mm into the company. These are newly issued shares so STOR further strengthened their capital base. STOR is now in a position to consolidate weaker players in the distressed retail REIT space.

There are other considerations. Let's quickly go through them in bullet points.

Just a really well run company
  • The basics all check out fine – geographic diversification, tenant diversification, inflation escalators…etc. 
  • Property investments require unit level profitability, not just corporate credit or property value
  • Great disclosure. Management collects abnormal amount of data.
  • Prudent debt levels with property asset covering debt by 2x. They use non-recourse asset backed funding.
  • No staggered board.
  • Unlike some of the REITs out there, STOR actually has good GAAP net margin.
  • 5% dividend yield is very sustainable and is well covered by AFFO (which closely tracks cash flow from operations before working capital)

Is The Market Wrong?
  • Retail REITs have been killed due to threats from Amazon. But STOR has differentiated exposure like health clubs, movie theatres, day care center...etc. They even have industrial/manufacturing exposure.
  • I’m not sure physical retail is dead just because of Amazon. Maybe physical retail still works but the business model needs to be tweaked. Amazon is actually moving to physical stores. If anything, Amazon’s recent purchase of Wholefood validates value of physical stores.
  • One of STOR’s clients, Gander Mountain, just entered bankruptcy, but that is only 2% of their rental income and another client is negotiating to buy them out. Gander Mountain’s troubles have been known for a while and I would be surprised if it’s not already priced in

Everything checks out great. Global bond yields have been going up the past week so dividend stocks have not done well. Once those bonds stabilize though, this should be a good one. 

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