Spirit Realty: In these returns, don’t look away (NYSE:SRC)

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Leading Internally Managed Net Lease REIT Spirit Realty Capital, Inc. (NYSE: SRC) is scheduled to launch its Third Quarter Earnings on November 8. Despite its discount to its peers, SRC posted a -16.4% YTD total return as investors analyzed the risk-reward profile of their returns.

SRC understandably took a hit despite its strong tenant pipeline. In the second quarter, 85% of your annualized base rent (ABR) consists of tenants with annualized income of at least $100 million (65% with more than $1 billion in annualized income). Coupled with a 99.8% occupancy rate, SRC investors can continue to count on the visibility of their AFFO.

Despite that, we found that SRC’s 10-year total return CAGR of 7.6% suggests that its share price gains have been relatively lackluster. Furthermore, the 10-year average of its NTM dividend yields (6.8%) indicates that its dividend yields have primarily driven its total return CAGR.

Therefore, Spirit Realty investors who focus on total return may have been disappointed in the REIT’s ability to generate better share price gains to supplement their distributions.

However, we find that the potential for investors to participate in a mean reversion opportunity looks relatively attractive at current levels. We discuss why we view the risk-reward ratio as favorable, although we do not view SRC as undervalued.

Additionally, investors should remain prepared for a worse-than-expected recession, which would cause value compression but vastly improve their risk-reward profile. Despite that, its price action remains constructive, even though last week’s rally surge could face some digestion in the coming weeks. So if you are not in a hurry, you may want to consider waiting for a possible pullback before adding more positions.

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We rate SRC as a Purchase.

Spirit Realty could find it difficult to shake off its lower relative valuation

SRC NTM Dividend Yields % Valuation Trend

SRC NTM Dividend Yields % Valuation Trend (koyfin)

SRC was last listed with an NTM dividend yield of 6.76%, in line with its 10-year average of 6.63%. Therefore, we do not consider SRC to be undervalued in this respect.

However, SRC’s NTM AFFO multiple per share of 10.7x is clearly below its 10-year average of 12.7x. Therefore, the market has already downgraded SRC, which is also implied by its YTD total return.

SRC’s AFFO per share trades at a discount to all peers (based on S&P Cap IQ data). Consequently, AFFO’s average multiple per share of its peers of 13.7x is notably higher than that of SRC. SRC’s relative discount was also noted by management on its earlier earnings call, as CEO of Spirit Realty

he stressed: “But I’d tell you like you know where our equity multiple is and it’s not good.”

Spirit Realty AFFO Change Per Share % Consensus Estimates

Spirit Realty AFFO Change Per Share % Consensus Estimates (S&P Capitalization CI)

We assess that Spirit Realty’s lower multiples could be attributed to its relatively poor per-share AFFO growth performance over time. Therefore, we posit that the market is unlikely to return to rating SRC in line with its peers unless the REIT can improve the consistency of its results.

However, revised (upward) consensus estimates suggest that Spirit Realty’s AFFO growth per share could decline during FY24. Therefore, a material re-rating is unlikely in the near term.

In addition, SRC’s markedly lower multiples could put it at a market disadvantage in raising equity financing without diluting its holders significantly more than its peers with higher multiples.

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As a result, Spirit Realty may need to rely more heavily on debt financing to fund its investment activity, which was also projected to slow in the second half of 2022. Therefore, we urge investors to continue to pay attention. to management comments on revisions to its investment cadence.

Additionally, reliance on debt financing with an aggressive Fed could further increase your interest expense, reducing your AFFO buildup.

Is SRC Stock a Buy, Sell, or Hold?

With these short-term headwinds, investors may find it difficult to assess whether there are appropriate opportunities to capitalize on recent bearishness on SRC.

We assess that its valuation has likely reflected a mild to moderate but not severe recession. Furthermore, management’s comment above did not suggest that it sees a severe recession as the base case. Therefore, investors should get significant clues about management’s updated macroeconomic outlook in upcoming earnings.

SRC Price Chart (Weekly)

SRC Price Chart (Weekly) (Commercial view)

We saw a potentially significant bottoming signal, which was validated in October. The massive move down from its August highs has likely shaken investors who tried to hit its June lows.

Coupled with last week’s bullish reversal, we assess that the risk-reward profile pointing to further upside over the medium term looks favourable. However, investors should have spare ammunition to prepare for a possible price compression if the market anticipates a worse-than-expected recession looming.

Our assessment indicates that its intermediate support looks like a potential bottom zone in such a scenario, which corresponds to the significantly undervalued zone according to its average dividend yields (zone two standard deviations above its 10-year average).

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Therefore, we assess that if the market anticipates a mild recessionary scenario, SRC appears to have decisively bottomed out at current levels.

We see a potential rally heading towards the $40 level before meeting strong resistance, implying a possible price upside (excluding dividends) of over 30% from current levels.

As such, we rate SRC as a Buy. However, investors who don’t want to buy into last week’s rise may want to consider waiting for a pullback first before adding.

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