Gladstone Land Stock: Current Valuation Is A Downside Risk (NASDAQ:LAND)
Over the last few years, it has been made public that large investors such as Bill Gates have begun to invest part of their assets in arable land throughout the entire American geography. The main reason why large super investors have decided to bet on crops is because crops have proven themselves to be a good defense against the investor’s greatest enemy: inflation over the last few decades. Gladstone Land (NASDAQ:LAND) is an agricultural REIT that since its IPO in 2013 has grown its FFO at rates of more than 20%, thanks to an asset acquisition policy that has been consolidating its position in the market. The management team is aligned and, although valuation and debt are at all-time highs, I think it could be an interesting opportunity if the company’s price drops another 50% in the coming months.
Description And Background
Gladstone Land is a Real Estate Investment Trust (REIT) engaged in acquiring, owning and leasing farmland all along the US territory. The products farmed in Gladstone’s farms are crops which are harvested annually (strawberries), other more stable crops such as almonds, blueberries and, to a lesser extent, more commoditized crops such as corn or soybean, which trade in Chicago’s Futures Markets.
Currently, LAND’s business is fundamentally focused on the purchase of arable land, seeking two objectives: increasing the number of assets under management to maximize the cash flows generated from rental income, as well as seeking revaluation of the land that is acquired year after year. Currently the value of the land in possession exceeds $1 billion.
Although investment in agricultural companies can be interesting at an individual level, it is true that there is a macroeconomic thesis behind the investments in these type of assets.
The main reasons to invest are the following:
- Increasing world population: Since the beginning of the Industrial Revolution (and hence since the arrival of modern Capitalism), population has systematically increased in the planet. Even though this increase seems to have begun slowing in the developed countries (US, Canada, Europe, Australia & Japan), other countries are starting right now to go through that path. It is estimated that by the end of the first half of this century, almost 10 billion people will live on this planet, and population will grow specially in underdeveloped regions such as Africa. Demand for agricultural products will be high.
- Reduction of arable land: another important point supporting the macroeconomic thesis for investing in agriculture is that arable land will decrease over the coming years. The combination of an increasing world population with industrialization and urbanization will have an impact on the amount of food demanded and the disposable surface to produce that food. On top of this, global warming and the changing of climate will most likely diminish the amount of arable area.
Business Strategy & Competitive Landscape
As it was stated previously in this article, Gladstone Land is a farm REIT whose objective is acquiring new farmland and collecting rents from the farmers that work on the land. In their presentations it can be seen that over the last years they have developed a very aggressive acquisition strategy selecting fit land to grow crops. The following list of points are figures considered to be important in the selection of farmland.
- Water Availability: The presence of water near the crops is essential for the company. In general, they look for land near wells or natural water sources that allow mitigating possible droughts that they may face. The lands where irrigation is done with rain are usually also very attractive places to make investments.
- Soil Composition: Another of the essential elements in the search for land is the composition of the soil, essential for the development of crops such as cabbage or red fruits. In general, the company buys land with good soils, and the presence of areas not suitable for cultivation is mainly intended for the construction of greenhouses, and places for crop maintenance.
- Location: Geographical location is another of the essential aspects required for investment in arable land. The vast majority of the land they own is located in fertile states with the right climatic conditions for the development of the products that are grown on the farms.
- Price: Although in the world of investment the quality of an asset is important, it is the discrepancy between price and value that allows returns to be magnified. The idea of investment in value applied to the selection of farms then makes sense. The company selects assets far from urban areas (the price is high and their yields are worse) and invests in them for the long term with the aim of achieving high visibility of income in the future.
In addition to the selection of land with good properties, the company considers as a priority the fact of selecting good tenants that ensure the recurrence of income over time. The company looks for a series of financial and creditworthiness characteristics in its tenants that are listed below.
- Experience: For LAND, this is one of the main qualities they look for in tenants on their land. Therefore, they seek to rent our properties to farmers that have an extensive track record of farming their property and particular crops successfully.
- Financial Strength: The study of the good financial characteristics of the tenants is another of the points considered to be essential. The company seeks clients with little risk, management experience and who are backed by credit rating agencies such as S&P (SPGI), Moody’s (MCO) or Fitch. They are usually very demanding and require access to annual accounts to check if the tenant will be able to pay the rent for the land.
- High Quality Standards: For the company, the quality of the products grown on the tenants’ land is of vital importance. This allows them to ensure that they sell the product and thus the company will be able to produce recurring income over time.
- Diversification: The company also seeks to diversify its operating activities so as not to be excessively dependent on any type of tenant, crop or specific geographic location. Specifically, diversification allows them to reduce the risk of adverse effects on their investment portfolio. This reduces the chances of sporadic losses that can negatively affect the company’s performance.
Indeed, finding land and tenants that meet these characteristics may seem complicated at first. However, based on the results offered by Gladstone, it seems that the strategy is working effectively.
First of all, the occupancy rate is always above 99%, which shows that there is a stable demand for this type of land. At the same time, this allows to guarantee visibility of future income. Below you can see the evolution of the occupancy rate over the last 9 years.
In addition to this, the company has also shown that its business is resilient. Over the last few years, it has proven that it is capable of raising rental income at a rate of 3% and not losing occupancy. Once again, another sample of quality and resistance of the business in any type of situation.
Despite the previously mentioned strength, I think it is important to monitor whether Gladstone is going to be able to maintain price increases throughout 2022, a year that seems complicated by the high economic uncertainty we are facing.
Once we have understood how Gladstone approaches its acquisition strategy, and therefore business growth, it is important to understand the competitive environment and who its main rivals are in the world of investment in farmland.
Although Gladstone Land’s business model is unique (due to the cultivation of non-commodity fruits and vegetables), there are other REITs that also rent farmland.
Farmland Partners Inc. (FPI): American real estate company engaged in acquiring high-quality crops to rent them to farmers as well as making loans to farmers securing them with real estate assets. Its main crops are wheat, corn and soybeans, whose prices are more volatile than those developed in Gladstone’s lands. Hence it is not Gladstone’s direct competitor. Farmland is less indebted than Gladstone (debt/equity ratio is below 100%) but its earnings are less predictable due to their commoditized nature. In fact, Farmland’s FFO per share has decreased at a rate of 15% annually over the last 5 years.
Power REIT (PW): American real estate company engaged in developing Controlled Environment Agriculture, where cannabis is grown for medical purposes only. This industry is indeed promising, as analysts expect it to grow at an annual rate of 22% in the coming years. This should allow Power REIT to benefit from the expansion of its addressable market. Power REIT’s debt to equity ratio is below 100%, and growth has been impressive over the last years. Nevertheless, it is in another niche market and it is not a direct competitor of Gladstone.
Over the last decade, Gladstone Land’s performance has been indeed impressive. Rental revenue has grown annually at a rate of 44%, while its FFO (Funds From Operations, the best metric to track a REIT’s performance due to the fact that Net Income is really depressed by the effect of depreciations and amortizations of properties) has grown annually at a rate of 45% over the last decade – a really positive sign that indicates that this company has been able to increase its profits faster than it is increasing its revenues.
Unlike other REITs that struggle to see improvements in their profits, LAND has grown this fast due to the aggressive acquisition strategy that they have adopted during the last decade.
Unlike other companies, which increase their portfolios solely with the cash from operations they generate, Gladstone has been issuing new debt to fund the acquisitions of land they make.
As you can see in the balance sheet, debt has multiplied by 20 times since 2012, something that will put pressure on the company for the coming years, in which it is highly likely that interest rates will remain high to fight the high inflation present in all Western economies. The way in which the company finances itself with debt is somewhat complex, since until the maturity date, which on average is about 10 years, part of the debt is made at a fixed rate (3.5%) while another part is made at a variable rate. To avoid the risk of excessive rate hikes, the company has hedged itself with interest rate swap contracts.
Another issue that must also be taken into account is the constant dilution to which the company has subjected shareholders over the last few years.
Although dilution is not bad in principle, it is true that maintaining it sustained over time has two very negative implications for shareholders: on the one hand, loss of value of the shares as long as there is no increase in company value and, on the other, inability of the company to finance itself with debt or operating cash flow.
Another of the main concerns regarding this company is the huge gap that exists between the cash flows from operating activities and the cash outflows, mainly related to the acquisition of new assets. Even though this might be possible during the short term, it compromises the financial health of the company. Should this gap persist in the future, it might force the company to sell assets and cut the dividend if debt refinancing becomes complicated due to credit restrictions in the economy.
Despite these financial problems and the constant debt and stock issuance, Gladstone has recurring and assured income due to the criticality of the products that are manufactured on its land and the credit and financial quality of the tenants, which reduces by a little the risk that the previous graph obviously entails.
Management & Addressable Market
Gladstone’s management team is led currently by David Gladstone, who has been on the board since 1997, from the date the company was founded. He also runs other investment firms associated with him and his family, although his specialty has been investing in farmland for a long time. Currently, insiders are aligned, and notably David Gladstone who owns just over 7% of the outstanding shares.
Another essential point of this thesis is the ability of the management team in making acquisitions that generate value in the long term. As I have discussed earlier in this article, there are clear tailwinds for investment in farmland over the next few years. In addition to this, the market is highly fragmented and there is a great opportunity to consolidate it by making good acquisitions at reasonable prices.
Currently, as can be seen in the image, the US market is highly fragmented, with 86% of arable land in the hands of smallholders. The total value of arable land stands at $2.7 trillion, while the value of the land held by Gladstone is $1.5 billion at the end of 2021. Such a fragmented market in an industry that is set to continue to grow in the years to come is a clear opportunity should the management team correctly execute the acquisition strategy.
My investment philosophy, although early, is influenced by Howard Marks, a person I greatly admire, who always emphasizes the importance of valuation in investments.
Lesson number one is that it’s not what you buy, it’s what you pay for it that determines whether you’ll be successful or not. Lesson number two is that successful investing is not a matter of buying good things; it’s a matter of buying things well.
I consider it quite wise and prudent to follow the advice of Marks and apply it to the case of LAND to determine whether or not it may be a good investment in the future.
- Enterprise Value: $1513 million, it is the company’s current market capitalization minus its cash & cash equivalents plus its outstanding debt.
- FFO: $23 million, it is calculated using the following formula: FFO = Net Income + Depreciation & Amortization (non-cash expense, that is why it is added back) + Loss on Property Sales – Gains on Sales of Properties – Interest Income. If you are interested in learning more about accounting ratios, you can check this website here.
The FFO yields is calculated at 1.5%, well below the US 10-year bond, which is currently at values close to 3% with expectations of somewhat transitory inflation. If it isn’t, the bond’s yield would go much higher, which could cause the company’s valuation to collapse.
Although the company is well managed, in an interesting market and its assets are of high quality, I believe that the current valuation is a risk that even a long-term investor should not take. As Warren Buffett says:
For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.
Once we have made this preliminary analysis of the company, I believe that the best way to study it is through the value of the land it owns, discounting the long-term debt it presents. That is, I will do an analysis of the company based on its NAV (Net Asset Value).
To calculate the NAV, I have taken the value of the real estate as it appears on the balance sheet, I have discounted the long-term debt, and I have added the current assets of the company, mainly cash in treasury and cash equivalents. Once this is done, we take the outstanding shares and thus obtain the NAV per share.
In the graph above, you can see the evolution of the NAV and the price per share over the last 7 years. In general, Gladstone has always traded at a premium to the NAV, due to the quality of the assets it owns. Currently, the premium is very demanding, as the price of around $27 is well above the NAV/share, which is around $18 per share.
In general, this type of holding requires a high safety margin (at least 20%) to be considered a good purchase. Consequently, an ideal price to consider a good buy would be below $14, well below the almost $28 at which the LAND stock is currently trading.
Once again it is proven that the current price of Gladstone, despite the recent correction it has suffered, is not a “bargain”. The damage that overpaying for an asset can do to an estate is high, especially when the company is trading at a significant premium to its NAV.
As you may already know, not all that glitters is gold. Even though Gladstone has performed extraordinarily well over the last year, the business faces several risks that I want to stress through the following points:
- Debt: For a business to be heavily indebted in an environment where interest rates may rise, it can be a severe blow to the company’s profits should interests on the debt increase. The current debt/equity ratio is over 100% at Gladstone, something that, although not excessively worrying in the world of REITs, could become a problem if the weight of financial debt increases.
- Bad acquisition strategy: Most of Gladstone’s growth has occurred inorganically, primarily through the acquisition of arable land from smallholders. If Gladstone overpays for acquisitions or selects lower-quality tenants to improve its financial performance in the short term, this can become a problem that translates into impairments and non-payment of rent in the coming years.
- Valuation: Without a doubt, the main risk facing any investor in Gladstone is the company’s valuation. Currently, the FFO yield is 1.5%, well below the value of the risk-free asset (currently 3%). In addition, the company trades with a high premium compared to its NAV. Buying Gladstone today can cause large losses in the medium term if the company’s valuation is ignored.
In my opinion, Gladstone Land is a great company, with a good management team and a good portfolio of agricultural investments. However, I believe that its high debt (greater than 100% of equity), together with its excessive valuation, make it a very risky bet in a market context in which volatility is extreme. Any long-term investor interested in Gladstone should wait until the company reaches price values of around $14-15. In that situation, Gladstone could become an interesting company for the long-term investor.