|Shares Out. (in M):||10||P/E||0.0x||0.0x|
|Market Cap (in $M):||222||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||0||EBIT||0||0|
What is ADC?
ADC is a REIT and their business model is very straightforward. They own property, lease it out, and generate rental income. Specifically, ADC owns 79 properties. The vast majority of their properties are standalone single-tenant retail locations (67 properties). Their largest tenant is Walgreens (30 properties). ADC enters into long-term leases with their tenants (their remaining term on leases is north of 11 years) and as long as their tenant honors the lease (ie, remains solvent), ADC receives rental income on the properties. Additionally, all of the leases that ADC holds with their tenants are "triple-net", meaning that the tenant is on the hook for the property taxes, insurance, and maintenance on the properties they lease from ADC. These expenses usually take the form of reimbursements from the tenants to ADC.
Why do we like the stock?
After Walgreens, ADC's second largest tenant is Borders (BGP)... As many people are aware, Borders filed for bankruptcy protection earlier this year, and recently announced they will be liquidating the company. Clearly for ADC, the Borders liquidation is not a good thing. ADC owns 14 locations that were leased to Borders. In liquidation, Borders will vacate their stores owned by ADC. To be clear, ADC will still own the stores, but they will be vacant, the existing leases w/ BGP will be terminated, and ADC will no longer receive rental income. ADC will then be reliant on selling the vacant locations or re-leasing them to gain back the lost income. The stock has gotten punished because of fears surrounding the impact of the Borders bankruptcy (down from a high of $29/share in December, to $21.50/share currently). It is our view that ADCs stock is significantly undervalued despite the Borders liquidation. We believe that ADC, at current levels, is pricing in very little of the value that exists from their Borders properties. We believe that management has, and will continue to unlock this value, and shareholders will be rewarded with a $30.00 stock in the near future.
We start with the worst case...
Here we outline what we believe would be the absolute WORST CASE with respect to Borders. We believe this is the best way to articulate the value here. We believe under the WORST CASE for Borders, ADC earns $1.66 in FFO, enough to cover the dividend. This is how we get there.
Q1 2011 Annualized FFO: $25.2mm
Less: 100% of BGP rental income: ($7.4mm)
Less: 100% of est BGP reimbursables: ($0.6mm)
Add: Interest relief on BGP non-recourse debt: $0.0mm
Adjusted FFO: $17.2mm
Adjusted FFO Per Share: $1.66 per share
We start with the Q1 2011 numbers, when all of ADCs Borders locations were fully-leased. In Q1, ADC generated annualized Funds From Operations ("FFO") of $25.2mm. For those of you who are not familiar w/ the term "FFO", it is a simple measure of cash flow of a REIT. Every quarter, REITs take a GAAP expense for depreciation on their owned real estate. This depreciation is a non-cash expense. FFO simply takes the GAAP net income, and adds back the depreciation expense. FFO is standard valuation tool among REIT investors, because it helps measure the cash earnings of a REIT, and how much cash is available to pay out dividends. So, Q1 Annualized FFO for ADC was $25.2mm. This is the starting point. We can think of this number as what ADC would earn if all of the Borders locations that they have remain leased. From this number, we make three adjustments to determine the WORST CASE for ADC with respect to Borders.
First: we subtract out ALL of the rental income from ALL of the Borders locations. ADC disclosed this number in a February press release when Borders filed for bankruptcy. They disclosed to investors that the 14 Borders properties generate $7.4mm in annualized rental income for ADC.
Second: we estimate the amount of reimbursements that Borders currently pays ADC as part of their triple net lease obligations (taxes, insurance, maintenance). Borders will no longer pay ADC for those reimbursements, and those costs will be borne by ADC until the properties are sold or re-leased. We estimate that the total Borders reimbursements are approx $0.6mm annually (total reimbursements to ADC are $3.0mm annually in Q1 from all tenants, and BGP represented ~20% of total stores, as well as ~20% of base rents).
Third: we make NO adjustment to the interest expense that ADC is currently paying to their banks to finance the property-level debt on some of their Borders properties. ADC discloses that of the 14 Borders properties, 7 of them are unencumbered (ie have no property level debt against them), but 7 properties have non-recourse property level debt, totaling approximately $19mm. The important thing to note about this debt is that it is non-recourse to ADC. This means that if Borders stops paying ADC, ADC can give the keys back to the bank, and the bank has no recourse to the remaining ADC assets. We estimate that this $19mm of non-recourse Borders debt has ~$1.0mm in annual interest expense that ADC pays to the banks. In our worst case numbers, make the assumption that ADC will continue paying on this non-recourse debt, even though Borders is not paying them rent.
There are 10.35mm fully diluted shares and operating partnership units at ADC.
At a $21.50 stock price, ADC is trading at under 13x what we believe to be a worst case scenario with respect to Borders (a liquidation, with ADC not re-leasing or selling any properties, continuing to fund taxes/maintenance at the vacant locations, and continuing to fund interest expense at the locations with non-recourse property level debt). In terms of comparables, it is hard to find REITs out there that trade at under 13x earnings, so we believe the stock is fully discounting a worst case scenario with respect to Borders.
There is also a way to help sanity check these numbers. On March 7th, ADC put out a press release announcing that they had reduced their annual dividend from $2.04 to $1.60, as a result of the Borders bankruptcy. Perhaps not coincidentally, the $1.60 in dividends represents a slight discount to the adjusted number we arrived at above. Also, in the press release, management made the following statement.
"Given the continuing uncertainties due to the bankruptcy of Borders Group, Inc., the Board of Directors has adjusted the dividend to a level that we believe should provide the Company with sufficient liquidity and flexibility to accommodate any further developments in the bankruptcy," said Richard Agree, Chairman and Chief Executive Officer. "This adjusted dividend rate reflects the conservative framework which has provided long-term value to our stockholders since the Company's initial public offering in 1994."
The way that we read this is that this dividend cut represents the worst case outcome with respect to Borders.
Now that we hopefully have gotten you comfortable with the downside (or lack thereof, as we see it), we will discuss the potential upside, which we believe is meaningful. This upside comes mainly from the fact that in the above analysis, we assume that Borders liquidates, and ADC can't do anything with the properties. However, management's top priority in either case is to maximize the value of the assets for shareholders, and we believe they have done a good job up until this point.
The following table outlines our estimate of aggregate value starting with our Worst Case estimate, and building up the value from each of the Borders locations. Below is a qualitative discussion of our assumptions. In summary, we believe that ADC, at current levels, is pricing in very little of the value that exists from these Borders properties. We believe that management has, and will continue to unlock this value over time, and shareholders will be rewarded with a $30.00 stock in the near future.
Adjusted FFO Per Share (Borders Worst Case): $1.66
Value from properties occupied by tenants other than BGP: $0.13
Value from currently unoccupied BPG properties: $0.11
Value from properties currently occupied by BGP: $0.17
Value from BGP headquarters: $0.05
Adjusted FFO Per Share: $2.12
Potential ADC Equity Value: $27.60
Dividends Next 12 Months: $1.60
ADC Year End Total Value $29.20
Total Potential Upside from Current Stock Price: >35%
As we mentioned, in Q1, ADC had 14 properties with the leases being paid by Borders. ADC gives very good property level disclosure, and we know the following about the properties.
1) 3 of the properties are currently occupied by tenants other than Borders
2) 4 of the properties are currently unoccupied
3) 6 of the properties are currently occupied by Borders
4) Borders Headquarters
Properties occupied by tenants other than Borders
First, there are 3 properties that are not occupied by Borders. Two of these properties were formerly sub-leased by Borders (here, ADC had a lease with Borders, but Borders did not occupy the buildings. Rather BGP sub-leased those buildings to other tenants, and paid Borders at a higher rate than Borders paid ADC). Importantly, ADC has been able to take control of these two sub-leases (this was announced in mid-June)... so for these properties, not only does the income from Borders not go away, it actually INCREASES, as ADC gets the higher rental income from the sub-tenant, as Borders is cut out as the middleman. The company disclosed that these two stores will generate $0.9mm in annualized rents (9c in FFO). The third property that is occupied by a tenant other than Borders was a former-occupied Borders location in Wichita, KS, which has subsequently been re-leased by ADC (also announced in June). ADC did not disclose the lease rate of this property, but at $12 per square foot, this would add another $0.3mm (3c). Both of these numbers are before reimbursements, which we would estimate to be another $0.1mm (1c), so the total value of these three properties should add $1.3mm to FFO versus our worst case, or 13c per share. These actions, which ADC has already completed, take adjusted FFO per share up close to $1.80, which represents a ~12.0x multiple on the current stock price. It is also important to note that of these three properties, two are unencumbered, and one has a nominal amount of debt (under $1mm).
There are 4 former Borders properties that are currently unoccupied. Of these, two have property-level debt, and two are unencumbered. The property level debt on the unoccupied properties totals ~$5mm. We estimate the annual interest cost on this debt is $0.3mm (3c). We assume that these two properties will be returned to the lenders, although there could be additional value if they can be re-leased. We assume the two unencumbered properties can be re-leased at $12/foot for total rental income of $0.7mm (7c), additionally, we assume another $0.1mm (1c) from reimbursables. In total, we believe there is value of $1.1mm in these unoccupied properties, or 11c per share in FFO.
Occupied BGP Properties
There are 6 properties that are currently still occupied by Borders. ADC put out a press release in June, disclosing that they renegotiated rents on these 6 properties, while Borders was still in the process of restructuring. Of these 6 properties, 3 are unencumbered, and 3 have property level debt. Under the renegotiated leases, the 3 unencumbered properties would have generated $1.4mm in annualized rents (14c), had Borders not liquidated. The renegotiated leases carried a rental rate of ~$9/square foot. If we assume a 20% haircut to that number to re-lease the properties in a liquidation, the FFO impact is $1.1mm (11c). The 3 encumbered properties have total debt of $6mm, with an estimated interest cost of $0.35mm (4c). We estimate that these properties will be given back to the lender. We estimate the reimbursements on these 6 properties to be $0.2mm (2c per share). Therefore, we estimate the total FFO impact of 17c per share of potential value from these 6 properties still currently occupied by Borders.
ADC owns Borders Headquarters, a 330,000 square feet building located in Ann Arbor, Michigan. This property has $5.8mm of debt and we estimate represents over $0.2mm of reimbursable property level expenses. The debt here to ADC is non-recourse, and we estimate that ADC would save $0.5mm versus our worst case (5c), if they gave the keys back to the lenders ($0.3mm in estimated interest expense on debt + $0.2mm estimated reimbursements). If they can re-lease this asset, further upside potentially exists.
This thesis relies on ADC continuing to execute asset level strategies to maximize returns on assets. We feel strongly that ADC management has displayed savvy thus far in the management of Borders assets, and will continue to do so. For example, in addition to taking control of the two sub-leased Borders properties, in Q1, ADC sold two properties that were leased to Borders. These two stores had been subsequently closed, even before the liquidation was announced. ADC was able to execute a sale at $130 per square foot on these two (now unoccupied) assets. This is especially interesting given that the total company is only valued at $80/ft! These actions by management give us confidence they will continue to execute, and maximize asset value for shareholders, however we would management execution here is a key risk. ADC has not yet given the keys back to any lenders on BGP properties. To us, this would be a significant catalyst, as it would give us further confidence that management is operating in the best interest of shareholders, and not focused on holding unprofitable properties. Although it is very early stage, we are optimistic that ADC will act rationally in this regard. They have already stopped paying on some of their BGP debt, and are working to renegotiate terms with lenders on their BGP debt. We believe that ADC understands the leverage that they have in negotiations given the non-recourse nature of their debt.
Additionally, there is a macro element to this story (albeit relatively small). ADC is somewhat reliant on the markets to not fall apart in order to re-lease properties. We believe that management has done a good job of re-leasing (having just recently announced a re-leasing of the Wichita, KS Borders location), and that this is their top priority. Additionally, we believe even if re-leasing of BGP properties is non-existent from here, there is still significant value in ADC above the current stock price. It is simply a matter of upside being more limited/taking longer to be realized. If ADC were unable to re-lease any more legacy BGP assets, target FFO PS would decline from $2.12 to ~$1.95. At a 13x multiple, ADC could still be a $26.00 stock even if they don't re-lease another property.
Finally, we have focused our discussion today on Borders, but we should discuss ADC's other tenants. With a REIT like ADC, there is always a risk of future tenant credit issues. We believe this risk is minimal at ADC, but deserves discussion. As we mentioned, Walgreens is their largest tenant, and Borders is second. Their third largest tenant is K-Mart, then the concentrations drops off meaningfully from there, and the vast majority seem to be strong credits (other tenants include CVS, Chase Bank, Loews, Kohls, Dicks). Initially, we were concerned about the potential risk from leases to K-Mart, however there is one point regarding the K-Mart leases. These leases were made a long time ago (over 20 years in some cases). The K-Mart leases carry very low rents per square foot (~$5.50/foot, versus ADC's single-tenant portfolio average of nearly $14.00/foot). Unfortunately, these leases still have very long terms remaining, which limit ADCs ability to step these leases up to market rents, however we believe these leases do help insulate ADC from K-Mart credit risk, given the below-market rents.
We believe the following catalysts will unlock the value inherent in ADCs business
* re-leases/sales of legacy Borders assets
* an agreement with their banks on re-negotiating debt; OR walking away from underwater BGP properties
* Dividend raise, once FFO increases due to asset dispositions/re-leases
We believe that ADC equity is misunderstood, with a stable dividend yield of ~7.5%, which we believe represents a floor, and significant upside appreciation of ~35% over the next 12 months.
Thanks for reading and we look forward to any comments/questions.