Tuesday, January 23, 2018

Spirit Realty: Leveraged Shopko Spinoff Uncovering Value

Spirit Realty Capital (SRC) is a triple net lease REIT focused on single tenant commercial real estate, SRC effectively makes middle market loans secured by real estate collateral.  The REIT is very similar to STORE Capital (STOR) which did a private placement with Berkshire Hathaway last year, the difference being Spirit has a high concentration to one troubled retailer, Shopko, that is creating an unwarranted discount in the shares.  REITs generally need their shares to trade at a premium to NAV in order to play the private/public valuation arbitrage game and grow, when a REIT trades a significant discount like Spirit does, it gets stuck and is forced to come up with a strategy to continue on a growth path.  Spirit was a net seller of assets in 2017, but it has come up with an interesting solution to fix their discount, in the second quarter they will be spinning off their Shopko assets along with the assets and debt related to one of their asset backed securitization vehicles called Master Trust 2014.  The spinoff will be named Spirit MTA REIT (SMTA) and is generally viewed as a garbage barge spinoff that's worthless, while it's likely to trade ugly initially, there's call option like value in the spin while more importantly allowing the parent company to shed its riskiest asset.  After the spinoff, Spirit should trade more inline with its net lease peers.

Here's how the combined SRC compares to its net lease peers:
Most REITs are going to look cheap compared to Realty Income Corp, but after the spinoff new SRC should look a lot like STORE Capital and that large discount between the two should close over time.

Spirit MTA REIT (SMTA)
The "bad bank" REIT will primarily contain two sets of assets (today they tossed in some more workout assets similar to Shopko that will be sold with the proceeds going into the Master Trust):
  • Shopko is a mostly rural (midwest and western US) discount store that's facing similar pressures to many retailers, its under-invested in its stores and sells ubiquitous products that you can buy almost anywhere.  It's target market is similar to Sears, its sort of an unfocused general store.  Spirit currently leases 101 properties to Shopko, representing 7.8% of its lease roll (prior to the spinoff), it recently became a secured lender of Shopko as well, advancing $35MM in the form of a term loan at a 12% interest rate.  The term loan will provide SRC/SMTA with quarterly financial statements and more direct insight into how the business is performing and also gives them optionality to separate the Shopko assets further if necessary.  SRC has been selling down Shopko assets in recent quarters/years, and will continue to do so at SMTA with the goal to completely dispose of the assets within 24 months of the spinoff.  With the proceeds from the dispositions, SMTA will contribute those proceeds to the Master Trust and lever it up.  The Shopko portfolio is debt free today, so in the event of a bankruptcy/liquidation at Shopko, the remaining assets at SMTA within the Master Trust shouldn't be impacted.
  • Master Trust 2014 (also seen it referred to as Master Trust A): Here's the interesting portfolio, the Master Trust portfolio is setup as an SPV, its bankruptcy remote from the rest of SMTA, and has a A+ rating by S&P with a 75% LTV.  The asset base is very similar to that of the rest of SRC, single tenant triple net leases, albeit a higher concentration of smaller tenants.  The effective leverage SMTA will be able to get inside the SPV is about 12x EBITDA.  I was able to locate the trustee report and the distributions to SRC have been pretty consistent over the past few years and they haven't stuffed the SPV with bad assets since announcing the spin.  Through the Master Trust and a new CMBS issue, SRC was able to raise an additional $698MM in debt at SMTA that will be used to reinvest in STOR/O/NNN like assets at SRC.
SMTA will be externally managed by SRC for an annual fixed fee of $20 million plus a $6 million property management fee.  There's additionally a one time incentive fee that triggers in the event of a change of control or the management agreement is terminated without cause after 3.5 years.  I think that shows you where management's head is at, if things work out, this entity will be merged away or some other transaction will take place within plus/minus 3.5 years.

Valuation
I had a simple model put together late last week to break out new-SRC vs SMTA, but today the company released an updated presentation that does all the heavy lifting for us:
New-SRC is the critical piece to the overall SOTP, after the spinoff it will be under leveraged compared to peers with a largely similar tenant roster, if it can re-rate to STOR's multiple (not suggesting it happens over night) it's a $9.75 stock ($0.65 * 15) versus an $8.50 price today, and that's a conservative approach since we already know they're going to have a lot of dry powder ($698MM from SMTA that they'll lever 2-1) to start the acquisition engine again, growing AFFO.

SMTA won't have any close peers that I'm aware of (please correct me if there is one) and will probably trade terribly initially as the investor base for SMTA will be much different than SRC.  SRC provided an NAV build in the presentation today, the $1.61 value in the Master Trust is likely pretty solid (as of January 2018) as its just refinanced and had a third party assess the value of the collateral as part of that process.
The Shopko and workout assets are a little trickier, SRC has been able to dispose of some Shopko properties at similar cap rates to what they're showing here, but its unlikely the public REIT market will assign a 9% cap rate to the Shopko leases.  Quick and dirty, I'd probably assign a 50% discount to the $2.34 NAV presented here for today's purposes although I like the spinoff for its call option like return potential if their reinvestment plan works given the leverage at the Master Trust.

$9.75 for new SRC + $1.17 for SMTA = $10.92 versus a share price of $8.50 today, or ~30% upside without accounting for any new investments either side makes with their growth capital.

Why is this so undervalued?  I think it mostly relates to the typical net lease investor base, REIT investors like simple and safe stories, this spinoff transaction while creative is far from simple and the headline concentration risk to Shopko has scared away many investors.  This spinoff should remove the tenant concentration risk, simplifies the story, and then through the reinvestment of the capital raise from SMTA, allows SRC to return to the market and show a growing AFFO/dividend stream which should also help raise the valuation.

Biggest risks here: 1) interest rates moving higher than expected, the majority of their leases do have escalators built in but they're long dated and the investor base is also interest rate sensitive as net lease REITs are viewed as a bond alternative; 2) general recessionary risks, particularly with retail, although SRC is trying to move more towards services based tenants, these are risky borrowers that often can't get traditional financing elsewhere so they turn to a sale-leaseback transaction.

Disclosure: I own shares of SRC

25 comments:

  1. Thanks for your piece - I own some SRC. I also own DDR which is doing a spin off of their Puerto Rican properties and lower quality US stuff. The remaining portfolio has a very high Green Street TAP score (65 on par with REG which trades at a 5ish cap rate). Using a 6 cap for new DDR (remain co) and using a 7.75% cap for the lower quality US stuff (they’ve been selling inferior assets around here in 2017) and a 9.5 cap on PR, fair value is $13+ vs a current price of just 8.50. Spin should be complete mid year.

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    1. Thanks -- I've been meaning to do a deep dive into DDR but haven't yet, sounds like a similar story.

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  2. and do you have any thoughts on the dividend being cut at the parent co? i'm assuming the combined dividend stays the same on a $ basis, but that at parent co on a $ basis the dividend gets cut. Given the amount of quant type investors in REIT land, I am wondering if the quants will interpret the dividend cut as a sell signal and just dump shares right out of the gate (creating a better entry point for the human beings that can understand what is really going on). any thoughts?

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    1. That's a good thought, but I think its not because of quant investors in REITs but more because of retail investors in REITs, they'll see it as a dividend cut even though its not. I didn't spend much time thinking about the impact on the dividend as its unimportant to me, but I could see it potentially being viewed as you describe and cause a temporary hit to the stock. But even if there is a "cut" at SRC, over time I would expect SRC to raise its dividend back up as they deploy their dry powder. Thanks for reading.

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  3. is the debt in the master trust at spinco completely remote from the parent? in other words, if shopco winds up chapter 11, is it your understanding that parent co is completely free and clear? i would think at the very least there would be litigation risk? any thoughts appreciated!

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    1. It should be, if SMTA blows up immediately, there could be some fraudulent conveyance risk. But taken a different way, if Shopko winds up chapter 11, SMTA should still be able to survive, there's no debt on the Shopko assets, it wouldn't impact the Master Trust assets or structure, but it would cut off SMTA's growth capital. But either way, I don't think Shopko would be the death blow, but rather a large recession that might wipe out SMTA's equity at the Master Trust because of the leverage in that structure. But good question and is a small risk out there.

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    2. Thinking about it a bit more, no I don't think there is any fraudulent conveyance risk because the only debt at SMTA will via the Master Trust and the CMBS transaction they did on one additional asset they just added, neither of which includes Shopko, and both of which are non-recourse to SRC or SMTA. But maybe I'm missing something?

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  4. Hello MDC. I have one general question. How do you find these situations? Are there some event feeds from the NYSE or Amex exchanges? In the UK, I use the RNS feed from the LSE (here http://www.londonstockexchange.com/exchange/news/market-news/market-news-home.html) which is a great free resource. It gives me a couple of "free money" trades a year (tender offers where my retail investor position gives me an advantage).


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    1. I don't do anything particularly scientific, I do scan EDGAR occasionally for certain filing types (Form 10-12 for spinoffs), but mostly I just read a lot and keep a notebook of ideas to revisit. I find that often jumping on an idea as soon as a spinoff or merger is announced isn't a great idea, there's usually a better entry point or the facts become clearer as you get closer to the corporate action. I do also scan for tender offers, but at least here in the US, most have changed to a Dutch Tender format so even though they'll include an odd lot provision, the uncertainty around the final price offsets the few hundred dollar gain. Thanks for the comment, maybe others have better 'hacks' they've developed.

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    2. Try google alert. It has been quite helpful.

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    3. What are some search terms you like to use?

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    4. I have a number of alert setup. From simple one to a bit more complex, you can experiment and tweak, e.g.
      IPO
      spinoff OR spin-offs
      tender offer
      bankcruptcy AND emergence
      REIT AND (conversion OR spinoff OR spin-off)
      etc.


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    5. Julien - could you please elaborate on what interesting opportunities you have seen in the UK? :)

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  5. Thanks for sharing your analysis. Any more thoughts on how rising interest rates might affect your investment thesis? I would think that if rates continue to increase, then the multiple applied to FFO on these types of stocks will have to decrease for the yield on these investments to stay competitive. Over the past couple of days, it looks like the price of SRC (along with its peers) has dropped as interest rates have risen. Curious if you have any other thoughts on this.

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    1. I think its a risk you just accept in something like SRC, if you want to get fancy you could do a pair trade with STOR but then you'd be responsible for the dividend. Given that SRC is selling at a lower multiple, it should have lower interest rate risk than its peers, but anything can happen day-to-day. But sure, I hope the discount doesn't close because the whole group falls and SRC just falls less. I don't spend a lot of time on macro, but I'd side with rates not shooting up beyond what's already forecasted. Thanks, good question.

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  6. Thanks for the idea! You mentioned that you were able to locate the trustee report. Could you share where this is located? Thanks!

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    1. https://sf.citidirect.com/

      They're listed as "Spirit Master Funding".

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  7. MDC, I didn't see Vereit in your comp, but trades at sub-10 P/FFO and 8% well-covered div yield. They do have some litigation exposure from past mgmt actions but nothing that should cripple the company. So that raises two questions: 1. How long does a multiple re-rate take? Vereit has been in their situation now for over two years. New management, doing all the right things, and metrics are terrific, yet, no re-rate. 2. If Vereit is indicative of what a "tainted" name trades like, is it possible that kind of stigma will stay with SRC even when Shopko is gone? I know the second point doesn't sound entirely rational but I think a many REIT investors do behave like Twain's cat. (“If a cat sits on a hot stove, that cat won't sit on a hot stove again. That cat won't sit on a cold stove either. That cat just doesn't like stoves.” - MT)

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    1. I don't know if Spirit and Vereit are "tainted" in the same way, but good comment on how long it might take to re-rate, I would have thought Vereit would have performed better since their accounting issues and dividend cut. Vereit also has a more grab bag asset approach compared to the other comps, a decent amount of office and industrial assets, but sure it's cheap too. I think the difference with SRC might be the dry powder, they'll have about a $1B to invest and show some growth in FFO, that's where it'll get a valuation uplift, not necessarily on the day the spinoff happens. Totally agree that many REIT investors aren't rational, that's what makes it a fun place to look for ideas. Thanks

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  8. Can you explain in a little more detail the mechanics behind how they will use the $698 million from SMTA that you say they'll lever 2-1? My understanding is that the $698 million in debt will be paired with roughly $350 million of equity (assuming the 2-1 leverage) to invest in new revenue generating properties costing around $1 billion. Where will the equity piece come from? Any estimate of how much FFO will grow once this capital is deployed?

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    1. I probably could have worded that better, there's no equity piece coming from anywhere, SMTA is sending SRC $698MM under the current plan. That $698MM is fresh capital that can then be used to purchase assets and lever up those assets, they'll have plenty of dry powder to deploy and grow FFO.

      As for an estimate, if you assume the $698MM goes to pay down existing debt, freeing up $1B in leverage potential, further assume they can achieve a 2% spread on the cap rate they're buying versus their financing costs (~7%-5%), that adds about another ~$0.04-$0.05 of FFO. At the 15 multiple, that could increase the value for $9.75 to $10.50, all back of the envelope math. Hope that helps (and that my math is right).

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  9. Have you seen any indication if the spin will be taxable or not?

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    1. I haven't, but I assume it will be to shareholders but its null to the company since its a REIT, I guess we'll find out more when they file the Form 10?

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  10. Hi, thank you for the write up. Just a quick question tho. If SMTA is expected to trade horribly at the start, and new SRC may take some time before it can close the valuation gap with its peers, then wouldn't it be a better risk/reward to buy after the spin off?

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    1. Possibly? Timing is tricky, I guess I'm just covering my bases here if it doesn't work immediately after the spin and coming up with reasons why it might not. The other way to look at it, SMTA will trade poorly after the spinoff, but you could also say its not being valued at all by the market today so it doesn't matter, its almost a free call option. I'm comfortable owning going into the spin and depending how each entity trades, may buy or sell either afterwards. But good question, hard to know the best strategy.

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