Tuesday, July 25, 2017

STORE Capital: Berkshire Deal, High Risk Lender?

STORE Capital (STOR) is an internally managed triple-net lease REIT, I don't own it (and usually don't like to write about companies I don't own), but Berkshire Hathaway (BRK) recently made a direct investment of $377MM for a 9.8% stake that deserves a closer look.  STORE is acronym for Single Tenant Operational Real Estate, basically it means they lend money primarily to middle market retail and service businesses using a sale-leaseback structure where the single tenant box is the collateral.  While STORE Capital is a REIT, it's closer to a BDC type lender than it is to an office, multifamily or even a mall REIT.  The tenants come to them because they need financing and can't get financing through more traditional bank lending.  The tenants then still control the property, pay the taxes, capex, and insurance, plus these are very long term leases, usually 15+ years.
STORE currently has 1750 properties, they're focusing on service sectors (restaurants, movie theaters, health clubs) as a way to mitigate the threat of online shopping, their largest tenants include Art Van Furniture, AMC Entertainment, Gander Mountain, Applebee's, Popeye's and Ashley Furniture.  Often the tenant is really a local franchisee of Applebee's or Ashley Furniture, and not the parent company.

There are plenty of triple-net lease REITs out there, it's a fairly common structure and a commodity business, if STORE does have a "secret sauce" its their focus on unit level profitability.  From their 10-K (click to expand):
To summarize, they strive to have each location be profitable to the tenant, not just the overall tenant themselves, that way if the tenant does get into financial trouble they'll want to hang onto those profitable locations through restructuring and not hand back the keys to STORE.  Again, think of STORE as a lender and not a landlord, they're not in the business of re-positioning a failed retail box into a higher and best use, just like a bank is not in a great position to manage the sale of a foreclosed home.  To facilitate this level of underwriting, STORE receives unit level financials on 97% of their locations, surely a useful data point that helps manage the growing portfolio.

Where the story gets a little promotional for me, STORE rates the credit quality of each tenant with an internal metric dubbed "The STORE Score".  Their tenants are almost entirely non-rated entities, last year they average an 8% cap rate on new investments, and again, these are entities that typically don't qualify for traditional bank financing.  Yet, based on SCORE's internal metric, 75% of their tenants would be investment grade if rated, or at least default at rates similar to a Baa2 rating.
Here's where I question the validity of the score, if I look at bank loans rated Baa2, I see the average coupon being something like LIBOR + 200 bps, no where near the equivalent to an 8% cap rate that STORE is receiving, what's the explanation?  The management team here is well thought of here, STORE was originally created by Oaktree in 2011 before going public in 2014, they're focused on doing smaller one off deals for the time being (likely will become more difficult as they grow), so maybe its just better management and the ability to do bespoke deals?  Possible, to me it seems questionable that they're tenants are really investment grade but at least STORE is doing their own underwriting work.

But promotion is part of the REIT game, STORE's real product is their own shares, in order for them to continually grow they need to raise more capital by issuing shares.  It's not entirely different than an asset management company marketing their funds and selling the product.  Berkshire Hathaway bought at $20.25, today the shares trade for $23.25, so accepting BRK's stamp of approval lowered their cost of a capital, probably a smart capital raise on STORE's part.  Depending on your assumptions for the fresh BRK capital, STOR trades for about a 6.0-6.5% cap rate today and if they're continually able to invest at 7.5-8.0% cap rates they'd be smart to continue to issue equity.

I'd peg STORE Capital at about fair value today and think it's reasonable to assume a ~10% annual return from here going forward.  Management lays out the math a bit in their presentation, but if you're buying in at a 6.5% cap rate today, levering it, reinvesting some of the cash flows, raising rents 1.8% per year, issuing equity to buy at 8%, dock something for defaults/recovery and the returns lay themselves out pretty well.
This is a better mouse trap than many other alternative investment products out there or a BDC/CEF, at least here you have the real estate as collateral, it should perform close to the overall market with lower volatility.  Given Berkshire's cash hoard, can't blame them for taking that proposition.
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I co-chair a monthly investment research group where we discuss special situations and just general value investing ideas, yesterday the topic was STORE Capital, if you're in Chicago and free on the 4th Monday of every month come join us.
https://specialsituationsresearchforum.wordpress.com/

Disclosure: No Position

16 comments:

  1. Hi, MDC. Have you looked at ESSX? Failed SPAC, assets (rental cranes) liquidated, and board is considering whether to proceed with total dissolution. They've announced they'll do an initial distribution from the asset sale by mid-August, and that it'll be 17-25 cents/share, with a further ~10 cents/share held in escrow for residual claims, etc., to be released (or not) in, I believe, the year after the initial distribution. Currently trades at ~.215 cents with some liquidity.

    Risks:
    -Board ignores shareholder vote and does not liquidate, and squanders remaining cash
    -Unsuspected liabilities arise, using remaining cash
    -First distribution, promised by Aug 6 (=60 days after June 8 completion of sale of Coast Crane), doesn't happen. Unlikely, but hey, until the money's in hand...

    I take the low estimate in the co's filing as legit low (i.e. risk of no distribution is minor), so downside = 17 cents, to be received in next 2 weeks.

    Upside = 25 cents in next 2 weeks, with 10 cents to follow.

    Obviously this is a tiny OTC issue but still strikes me as attractive risk/reward.

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    1. I don't know ESSX, thanks for the idea, I'll take a look.

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    2. I like this one, might try to join you, only thing I noticed - the escrowed piece is $500k in 100 days, $1MM in 1 year, and then the remaining $1MM in 2 years. Still attractive.

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    3. Whoops, embarrassed to say my eyes glazed over reading the filing and I missed that timing. The only thing which gives me pause in adding to my (medium sized) position is that they are giving themselves 60 days post-sale for initial distribution. I'll give them the benefit of the doubt that they're allowing that time for a cleaner view of liabilities and not for Champagne baths for the board, but will be watching closely over the next week.

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    4. 1st distribution on this now pushed to 90 days ("before mid September"), which co claims it communicated to shareholders. They might be tying up loose ends but I worry that this will become another Laurence Levy rabbit hole.

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  2. It's just a bank let's be honest. But instead of a bank source of capital being depositers and the central bank, (or other banks) i.e. debt, these guys sell stock. Equity capital is always more expensive than debt capital as a source of funds. Again, a bank lends it out, STOR here is doing the same, and earning a spread.
    BRK probably bought at book value less a margin of safety...

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    1. Yep -- but there's a reason why banks don't make these loans, too risky, but then on the flip side, STOR's funding is more long term and stable than a bank that relies on depositors.

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  3. I started looking at STOR but it struck me that it was fairly valued and I was just pretty much betting on management. They have a track record for sue but I lost speed as I flipped the Store University materials on the site. I didn't like him using OPM and YOM in describing the basics of valuing a business. I remember these from Kiyosaki years ago and thought he was full of it. Also, this is very minor, but bow-tie guys (like Volk) always give me a little cause for concern. Nice write-up MDC, thanks for posting.

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    1. Yes, for sure, the Store University stuff is a turnoff. Thanks for reading and commenting.

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  4. any thoughts on STAR's earnings?

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    1. I bought a little more today. Earnings seem to be as expected, we knew about STAR and the Lennar settlement, don't fully get the market's reaction? My worry now is what Sugarman is going to do with all the cash coming in the door? Mentioned senior living and single family homes on the call, makes me concerned that this story is going to get more complicated in the future, not less.

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    2. I don't get the market reaction either. One potential cause is because Mr market is focusing on earnings primacy (though this is a balance sheet story). STAR did not raise their 2017 earnings guidance despite having great earnings for Q217 (Lennar lawsuit, SAFE transaction).

      I hope Sugarman buys back stock or starts a dividend instead of plunking it on senior living.

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    3. The company did raise guidance on their Q1 call to account for Lennar and SAFE since those had already occurred at the time of the call, so I don't think its an earnings thing, my best guess is a lack of clarity of the long term strategy.

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  5. Curious if you have any thoughts on GRBK's quarter and conference call. Continue to appreciate your blog.

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    1. Very quiet. When are they going to lever up somehow? Ever since the big capital raise they've struggled to grow into their new equity base. I'm willing to be patient, they'll clean out their NOLs in 2-2.5 years, then Einhorn/Loeb will push to sell it?

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  6. If GRBK makes an acquisition in Colorado and no one notices it, does it really exist? I am not an expert but have enjoyed following and owning this one for the long-term because of the NOL, who the owners are, the aligned incentives and it seems like a nice fit and a great market to enter. Any thoughts? Again, appreciate your blog which along with the Brooklyn Value Investor are my two favorites. Have learned a great deal from both of you.

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