Description

Quick Thesis: Spirit Realty is trading at 13x EBITDA, a 20% multiple discount to peers largely due to one poor tenant that is being spun out at roughly the same valuation as consolidated Spirit (13x or more!) for reasons explained below. Pre and post spin, RemainCo should re-rate upwards, generating a 40% return to the equity over the next 9-12 months.

Spirit Realty is a REIT that invests in single-tenant triple-net real estate properties engaged in the retail, service, and distribution industries.  We are excited about this idea given the near-term catalysts that will create value for shareholders.

We think that a) Spirit’s new CEO with a strong track record and b) a transformational spin-off serve as near-term catalysts in generating the aforementioned upside.

Business Overview

Spirit is a highly diversified REIT geographically and with respect to its tenants. Its tenants, for the most part, are high quality companies including Walgreens, Home Depot, Circle K, Carmax, FedEx, and Family Dollar to name a few. The company has 2,549 properties and 432 tenants. 37% of Spirit’s tenants are investment grade rated. Spirit’s average remaining lease term is 10.3 years.

60% of contractual rent is tied to service industry clients. 34% of contractual rent is tied to retail. However Spirit has little to no mall based retail exposure and is highly diversified by end market within the retail space (see below for breakdown). We estimate that organic same-store rent growth should average ~1.5% per annum based on the contractual disclosures provided by the Company.

Valuation Discount

While the quality of Spirit’s properties and tenants as a whole are similar to peers, it currently trades at a significant discount to peers on a levered and unlevered basis. On a levered basis (AFFO), peers currently trade on average at a ~50% premium to Spirit. Excluding Realty Income, which REIT investors believe to have a best in class mgmt. team (although we would argue a similar level of property and tenant quality to Spirit), peers trade at a 40% premium to Spirit. See below.

Spirit also trades at a discount to a very liquid private market that transacts at an average ~6% cap rate.

Why? Two reasons which we provide some additional detail on below.

Reason 1 for valuation discount: Shopko

Spirit’s largest tenant is Shopko which makes up 7.9% of contractual rent, down from 30% at the IPO in 2012. Shopko operates a chain of 363 retail stores across the West and Midwest. In late 2005 Shopko was purchased by Sun Capital, a private equity firm notorious for over-levering and underinvesting in businesses.

Shopko, like other retailers, has been hurt by the decline of traditional brick and mortar retail. While there are no public financials for Shopko, Spirit reports Shopko’s SSS each quarter for the Spirit owned stores. Over the last 3-4 years, Shopko’s comps have averaged -3% to +1%. Not great, but not a disaster. Currently, there is no debt on Shopko outside of an ABL facility.

Given how aggressive Sun has been with respect to taking cash out of the business, investors believe it’s a matter of if, not when the business goes bankrupt. While we believe that this business could be fine for the next few years, we admit to not having much insight into if and when it goes bankrupt.

Most investors, even more so REIT investors, HATE this type of uncertainty and have ascribed a significant discount to the value of Spirit’s equity as a result of this low-quality tenant. Note that Shopko makes up ~8% of contractual rent and ~13% of AFFO. In a worst case scenario where Spirit is unable to sell these boxes post Shopko bankruptcy or re-lease them (which we very much doubt), it would be a 13% hit to AFFO. Yet Spirit trades at a ~40% discount to peers.

Let’s be clear. We don’t like Shopko and think it will eventually go bankrupt (even if it’s 3-4 years from now). We just don’t think that the discount attributed to Spirit as a result of Shopko’s exposure makes much sense.

During our diligence on Shopko (while being cognizant that it’s a brick and mortar retailer) we found some positive data points that lead us to believe that parts of Shopko have significant value (particularly it’s fast growing hometown business). We are happy to go into those details in the Q/A if people are interested.

In summary, we think that a total write-off of Spirit’s Shopko properties is unlikely and a more likely scenario is a new sponsor buys Shopko from Sun in conjunction with rent concessions from Spirit (and/or partial store closures) and improves the business.

The important thing to remember, however, is that EVEN IF there was a complete writeoff of Shopko, Spirit still trades at an absurd discount to its peers.

Reason 2 for valuation discount: Q1 ’17 Earnings

In Q1 ’17 under the old CEO Tom Nolan, Spirit put up a disappointing quarter.  In reality, what happened was a combination of weak results and terrible communication by the old CEO.

Most REIT investors involved with Spirit are focused on the Shopko risk. In Q1, however, Spirit had issues in other parts of its business (a couple small bankruptcies in its portfolio that took same store rent negative) which people weren’t prepared for. This was a one-time event and has already been cleaned up.

The weak results combined with certain comments by the old CEO on Shopko caused people to freak out. The stock was down 25% that day. In comes the new CEO….

Catalysts / Thesis

#1: New CEO

After the debacle that was Q1’ 17, the board appointed COO Jackson Hsieh, CEO of Spirit. Jackson had been at Spirit for one year and is a 30 year veteran of the real estate industry on the banking side. He was previously a Managing Director and Vice Chairman of Investment Banking at Morgan Stanley.

Our conversation with Jackson and his comments since he’s taken over are a revelation. Jackson is focused on improving communication with shareholders (he has reached out to many shareholders since Q1) and avoiding financial missteps (Q2 was an excellent quarter and we believe the rest of the year will be fine).

Most importantly, Jackson is an aggressive manager who is focused on creating value for shareholders.

#2: Transformational Spin

Soon after Jackson took over, he announced a clever transaction that will create significant value for shareholders.

Jackson is spinning off Shopko and a number of other properties into ‘SpinCo’ which represents about ~1/5 of AFFO. While Shopko is being spun with no leverage on it, the other spun assets are financed by a Master Trust that will be levered at 12x EBITDA. The key to the transaction is that the Master Trust assets have an appraisal value of $2.36 billion (NOI yield of 6.7%) vs a gross book value of $1.9 billion. The master trust allows for a 75% LTV ratio, which leads to the 12x EBITDA. As a result, consolidated SpinCo will have 10x leverage on it. The spin will occur in Q2 ’18.

Think about this. All of Spirit currently trades at ~13x EBITDA and SpinCo (w/ Shopko) will be spun out with 10x of debt and a likely valuation of ~13x all in  (~16% AFFO yield).

Even if Spinco’s equity trades at zero (which we doubt), Jackson has gotten rid of Shopko at a valuation similar to where all of Spirit is trading today.

RemainCo will represent ~80% of AFFO post spin. At 4.5x, it will be almost identical to peers in terms of leverage and asset quality.

RemainCo’s new tenant roster is similar, if not superior (less concentration among the top 10 tenants), to the best in class peer Realty Income. What is also important to note is that Spirit's rents do not appear to be out of line with peers on a per square foot basis.

Take a look below at what happened when ADC, one of Spirit’s comps, worked through its Borders and Kmart exposure, which represented 31% of rent in 2011. A significant re-rate in-line with peers (the grey line).

Valuation

Assuming SpinCo’s equity trades at a very low value, let’s say $1 per share (20% cap rate, 16% AFFO yield, implied cap rate on ShopKo properties of 25% and 8% on the Master Trust assets) and RemainCo’s AFFO multiple closes the gap with NNN or ADC, we see roughly 40% upside in the stock. Given that RemainCo will likely grow over the next few years as a result of its lower cost of equity and that our valuation of SpinCo is conservative, a bull case could see an additional 15-20% upside.

If we ascribe no value to SpinCo and RemainCo trades at a 30% discount to peers (our bear case), we see roughly 10% downside to the shares.

Catalyst

New CEO

Spin-off of Shopko and other assets

Quarterly performance (normalized)