NNN Under Review for Sale as April Rent Paints Bleak Picture

National Retail Properties (NNN) reported earnings yesterday and revealed that a dismal 48% of rent went uncollected in April.

May could be even worse than April as shutdowns persist and more businesses grapple with reduced economic activity and no return to normalcy in sight.

Troubling NNN is the firm's high exposure to several industries impacted heavily by the pandemic, namely restaurants (19.9% of rent), family entertainment centers (6.7%), gyms (5.2%), and theaters (4.7%).

NNN's focus on non-investment grade tenants may be hurting performance as well. Management noted that they were more successful collecting rent from investment grade tenants, who comprise only 18% of NNN's portfolio.

The company is in discussion with tenants accounting for 37% of rent to defer several months of payments. However, many tenants operate on thin margins, making it unlikely they'll ever have capacity to pay back rent in full.

Moreover, some tenants may go out of business if conditions don't improve quickly and government stimulus fails. Vacancies will be difficult to fill in the current environment with many brick-and-mortar stores reeling.

Based on NNN's pre-pandemic rental income and operating expenses (most of which are fixed costs), we estimate rent revenue could decline between 15% and 20% before cash flow (i.e. AFFO) would fall short of covering the dividend.

A decline in rent on the order of 15-20% was virtually unthinkable prior to the pandemic. During the last recession, NNN's same-store rent actually grew.

But April's disheartening figures, combined with waning prospects for a quick economic recovery in the next few months, indicate that NNN's payout ratio will meaningfully exceed 100% for the foreseeable future.

As a result, we are downgrading NNN's Dividend Safety Score to Borderline Safe. A further downgrade to Unsafe could happen by July if substantial progress has not been seen across NNN's key impacted industries (restaurants, gyms, etc).

We are also placing NNN under review for sale in our Conservative Retirees Portfolio given the widening range of outcomes facing the business. 

 

Barring a faster than expected recovery in parts of the retail industry, the stock no longer looks appealing for a portfolio whose objectives include safe dividend income and capital preservation.

If we decide to part ways with NNN in our Conservative Retirees Portfolio, we will notify customers by email prior to making a trade.

Management did voice their desire to preserve the dividend if conditions improve. NNN is in no rush to throw away a 30-year dividend growth streak and doesn't want to take action on the payout based on just one or two tough quarters.

Supporting NNN's dividend during this rough stretch is the firm's strong liquidity position, healthy balance sheet, and minimal capital requirements.

As of the end of March, NNN had $217 million in cash on hand and had access to an additional $900 million through a revolving credit facility. For context, the dividend costs about $350 million annually.

With property acquisitions on pause and less than $2 million in debt coming due for repayment through 2023, NNN is situated to have few needs for cash this year outside of paying the dividend (and covering normal operating expenses).

NNN also has a BBB+ credit rating from Standard & Poor's and came into the crisis with debt metrics at healthy levels, so the firm can afford to dip into cash reserves or issue debt to cover a temporary shortfall in the dividend's funding.

The question is how long management, who warned that "by no means is the dividend untouchable," will tolerate a payout ratio well above 100%. If rent doesn't appear likely to rebound to pre-pandemic levels anytime soon, a dividend reduction would be prudent to avoid eroding the firm's financial flexibility.

All said, there's plenty of bad news baked into NNN's current share price. Things could get worse in retail, though, so investors should weigh whether they're comfortable owning the stock given the precarious situation the dividend is in.