STORE's Tenant Mix Likely Impacted Significantly by Pandemic

STORE Capital (STOR) is a triple-net lease REIT with a highly diversified portfolio of tenants that operate in 49 states and over 110 industries. No single tenant accounts for more than 3% of revenue.

STORE hasn't provided an update to investors since coronavirus-related shutdowns began in earnest in late March, making it challenging to assess the impact of the pandemic on the firm's tenants.

However, our preliminary analysis suggests that STORE's tenants may be significantly impacted by shutdown orders and what will likely be extremely challenging conditions this year for restaurants, gyms, entertainment venues, retailers, and more.

As a result, we are downgrading STORE's Dividend Safety Score to Borderline Safe. STORE's rating could be upgraded or further downgraded as the pandemic unfolds and we learn more about the financial state of tenants.

Spirit Realty (SRC), another REIT, revealed on Monday that the firm had received rent deferral requests equating to about 40% of revenue. Deferrals range from 30-90 days and are to be paid back within 12 months.

Based on Spirit's breakdown of rent deferral requests by industry and our own analysis of STORE's portfolio, it's possible that STORE has received similar requests from somewhere between 40% and 60% of tenants.

Tenants in STORE's portfolio that are most directly in the crosshairs of the nation's response to the pandemic include restaurants (14.5% of rent), health clubs (5.7%), and movie theaters (4.0%).

STORE's leverage in rent negotiations is greatly reduced by the fact that finding replacement tenants is difficult right now. Few, if any, brick-and-mortar businesses will be seeking to expand or move during the pandemic.

Nevertheless, rent deferral requests are not necessarily the major issue since STORE will presumably receive what the firm is owed in due time.

Instead, the larger questions are what lasting effects the pandemic will have on tenants and whether tenants will eventually be able to pay rent in full (or at all).

The bottom line is that STORE is unlikely to collect rent in full this year (and perhaps next year, too). But the extent and duration of the hit is highly uncertain.

Given the uncertainty, let's look at the margin of safety for STORE's dividend.

On a call with investors on March 31, STORE's CEO said that the board believes "the dividend should be paid from cash flow and not from borrowing."

Companies with strong dividend commitments will sometimes borrow money (i.e. issue debt) to cover a temporary shortfall in the funding of the dividend. But this recourse does not appear to be in the cards for STORE.

The good news is that STORE's strong financial position and revised short-term growth plans should provide management with the flexibility to divert almost all cash flow to the dividend this year.

As of March 26, STORE had a cash balance of $630 million after drawing the full amount of its revolving credit facility. STORE also has virtually no debt due for repayment this year and only $200 million in debt maturing in 2021.

STORE also stated in mid-March that, in response to the pandemic, investments in growth projects would be limited to around $100 million for the remainder of the year. Initially, the firm had planned to spend $1.2 billion on acquisitions.

In other words, STORE is now situated to have few capital needs this year outside of paying the dividend (and covering normal operating expenses).

Adjusted Funds from Operations (AFFO, a measure of free cash flow) from Q4 2019 was $460 million annualized, and the dividend costs $320 million annually. So cash flow could drop $140 million, and the dividend would still be covered.

All else equal, a $140 million decline in cash flow would equate to a 22% drop in rent revenue, which was $650 million annualized as of Q4 2019.

A 22% hit to rent revenue would be extraordinary, but the current crisis is unprecedented for STORE and the company's tenants.

The question is how likely a decline in revenue of that magnitude is, as well as how optimistic STORE is that cash flow will quickly return to pre-pandemic levels so the firm can have more flexibility to continue growing.

Management has historically expanded the business at a fast clip, compounding STORE's revenue by more than 25% annually over the last five years.

Over $5.5 billion of property acquisitions (net of disposals) fueled STORE's growth during that period, and a high payout ratio would have slowed those efforts. 

STORE's payout ratio historically sat near 70%. The REIT used the cash flow retained after paying dividends to fund over 10% of its net acquisitions. 

Management has emphasized the importance of maintaining a low payout ratio, so it's difficult to say how long a payout ratio closer to 100% would be tolerated.

For now, the increased uncertainty surrounding STORE's near-term prospects justifies the downgrade to Borderline Safe.

If it becomes clear that cash flow will cover the dividend and that STORE's long-term outlook (including plans to finance growth projects) is still intact, then an upgrade could be considered.

On the other hand, if evidence arrives that cash flow is unlikely to cover the dividend for the foreseeable future, then another downgrade would be issued.

The response of governments to the pandemic, federal aid for small businesses, and consumers' appetites to quickly return to normal life are all wildcards.

Given how quickly the current situation is evolving and that investors aren't privy to the same realtime information about tenants as management, it's possible STORE could cut the dividend before there's an opportunity for us to reassess.

All said, a lot of bad news is baked into STORE's share price. Things could get worse, though, so investors should consider whether they're comfortable owning a stock with such a high degree of uncertainty in the near term.