Description

American Realty Capital Properties (ARCP) is a triple net lease REIT that is cheap on both a relative and absolute basis, trading at a 40%+ discount to peers and a 9% run-rate free cash flow yield. With recent governance changes resulting from activist pressure, simplification of the story, and management hitting run-rate earnings guidance, we believe ARCP will likely close much of the trading discount vs. its peers. We are recommending going long ARCP, potentially hedging with National Retail Properties (NNN) and Realty Income (O). 

ARCP’s main business (~95% of TEV) is very simple. The company invests in mostly single tenant net lease properties that are occupied by a mix of investment grade (46%) and non-investment grade (54%) tenants. The largest tenants include Red Lobster, Walgreens, CVS, Dollar General and Fedex, with the top 10 accounting for 62% of the portfolio.

ARCP originally IPO’d in 2011 and grew rapidly through a number of major acquisitions, often through the issuance of equity. It is now the largest net lease REIT, with a TEV of $22bn. Realty Income is the next largest in the space with a TEV of $15bn.

Over the past 3 months, the company announced a series of transactions: acquisition of a $1.5bn portfolio of Red Lobster assets from Darden Restaurants, sale of its multi-tenant assets (which the company had previously planned to spin off) to Blackstone / DDR for $2bn, and an equity raise of $1.6bn, with the proceeds used to delever.

ARCP has underperformed peers by 15%+ YTD. The company continues to trade at a huge discount despite having, in our view, a portfolio of equal or superior credit quality vs. peers, a conservative balance sheet, and recently improved corporate governance. We believe the significant discount is mainly due to distrust of the management team in the REIT community and concerns around numbers.  We address each of the main concerns below.

• Issue #1: REIT investors believe that ARCP is too levered relative to peers; cap rate is the right metric as opposed to AFFO

REIT investors push back on the size of the discount vs. peers and prefer to look at the valuation on an unlevered, pre-G&A cap rate basis. On our math (there are some moving parts depending on how one values Cole Capital, discussed below), ARCP is trading at a 10-15% discount to O / NNN on a pre-G&A cap rate basis but 40%+ on an AFFO basis. The difference in cap rate vs. AFFO valuation is a function of i) scale (ARCP’s real estate segment cash G&A as a % of NOI is far lower than peers); ii) leverage (ARCP is 1-1.5x more levered than peers including preferred stock) and iii) cost of debt (most of its debt has been issued in the last couple years).

We believe the right way to look at this business is on a levered basis, with ARCP’s scale resulting in lower cash G&A spend and slightly higher leverage accreting to the benefit of shareholders. A difference of 1 – 1.5x of leverage does not meaningfully increase ARCP’s probability of default compared to its net lease peers.  In fact, we’d argue that these businesses should all be levered more than 5-6x EBITDA.

Ignoring the relative valuation for a second, let’s address the absolute valuation of the company. This is essentially a levered portfolio of secured, mostly investment grade credits that grows AFFO organically in the low/mid single digits. The company also has a proven mousetrap for aggregating assets accretively through i) one-off, smaller sale leasebacks at ~8% cap rates; ii) larger corporate sale-leasebacks (other net lease companies simply cannot take down portfolios the size of Red Lobster, for example) and iii) larger portfolio transactions, potentially sourced by buying in Cole Capital’s nontraded REITs over time (ARCP is the best buyer as it acquired the assets and does not have to pay itself the sponsor’s promote).  This doesn’t sound to us like a business that should trade at a 9% FCF yield and 7.6% dividend yield.

• Issue #2: ARCP’s nontraded REIT asset management business (Cole Capital) is difficult to forecast, has long-term headwinds  and deserves a discount

ARCP purchased Cole Capital through the acquisition of Cole Real Estate in early 2014. Cole Capital raises capital from retail investors through a network of independent brokers. The products are pitched as low-volatility (simply because there isn’t a daily public market print), high yielding instruments. Cole earns fees on raising capital, deploying capital and managing the funds, and also a back-end promote if they achieve 8%+ IRRs. Upfront fees are usurious, but Cole actually makes most of its money from capital deployment and annual management fees, with nearly all of the upfront commissions being reallowed to brokers.

There are some legitimate concerns around the sustainability of this business due to proposed regulations from FINRA on fee disclosure, which will require the initial mark to reflect the large upfront fees charged to customers. This might depress capital raising activity once the rules are effective (likely in late 2015 or early 2016), but there is a real possibility that the addressable market for nontraded REIT products will actually grow as fees decline (which mainly hits the brokers rather than Cole) and transparency improves.

There is also concern around the sustainability of the private to public arbitrage that Cole and other nontraded sponsors currently exploit. In order to generate returns net of fees the sponsor has to aggregate assets at 7-8% cap rates and flip the vehicle to public markets through a sale or IPO at a 6-6.5% cap. A virtuous cycle is created when nontraded REIT shareholders sell their new publicly traded shares and plow capital back into Cole’s new vehicles. We agree that this dynamic is a bit uncomfortable, but think this business is unlikely to fall off a cliff as quickly as some seem to fear – let’s also not forget that this business represents ~5% of TEV and ~10% of equity value.

• Issue #3: CEO Nick Schorsch is an empire builder, terrible capital allocator, doesn’t care about the stock price, and has too many affiliated companies through which he profits to the detriment of ARCP shareholders

There is a general perception amongst the REIT community that Schorsch is a terrible capital allocator and an empire builder who overpays for assets and grows for the sake of growing. We can understand where this sentiment comes from – with the benefit of hindsight, the path Schorsch took to build ARCP from a $200mm to $12bn market cap company was far from perfect and was plagued by a few missteps and poorly timed transactions, including the recent large equity raise.  Until early 2014, ARCP was an externally managed REIT. Rather than having an internal management team, ARCP paid fees based on invested capital to an external management company, which was owned by Schorsch. For good reason, investors hated this structure as incentives were not aligned between management and shareholders. As the external manager, Schorsch was incentivized to get bigger, perhaps with little regard for creating value for ARCP shareholders. In connection with the Cole transaction, ARCP finally internalized its management team and subsequently hired David Kay and others to run the company along with Schorsch.

The important question at this point is whether management is properly incentivized and understands how to create value for shareholders going forward. Schorsch and the rest of the management team now own $250mm+ of ARCP stock and agreed to take nearly all of their 2014 compensation in stock.

We take recent actions by the company as evidence that Schorsch is stepping away from operating the business. Under activist investor pressure (including Fir Tree and Marcato), ARCP announced a number of governance changes including de-staggering the board, removing board members with conflicts of interest with other ARCP- affiliated entities, and the eventual succession of David Kay to CEO and to the board in October 2014. David is a top tier manager with a history of creating value for investors in his previous role at Capital Automotive, eventually helping to engineer a privatization at a premium for public shareholders and generating outstanding returns. We have had numerous conversations with David, who fully appreciates the reasons for the discount and has made clear his intent to close the valuation gap over time. David clearly seems to understand that the benefits of scale have already been achieved, as ARCP is now of sufficient size to attack large corporate sale-leaseback transactions that were previously too big for any net lease company.  If we are wrong and management doesn’t understand how to create value, there should be some backstop from the activists.

• Issue #4: ARCP’s numbers are questionable

We believe that investors who are willing to do the work can bridge to management’s numbers. Our discussions with several investors and sell-side analysts suggest that historical skepticism around the stock and a lack of willingness to do the deep dive has scared some investors off near term. For the past several quarters, there has been an enormous amount of complexity around the numbers given how many deals the company closed in a short period of time. The company did not help themselves with a few errors in public filings and presentations, but David is very focused on restoring credibility and has since bolstered his accounting and finance teams. Capital raising and deployment is also very lumpy within Cole Capital, which creates earnings volatility quarter to quarter.  Cole Capital’s earnings have been temporarily weak since the transaction closed, which certainly has not helped inspire confidence in the earnings power of the business. As transaction activity slows and Cole Capital fundraising and capital deployment ramps in the 2H of the year, we expect a lot of these concerns to fade.

Catalyst