Realty Income Stock: The More It Falls, The More Tempting Its Dividend Story (NYSE:O)
The REIT Investment Thesis Has Been Discounted By The Elevated Interest Rate Environment
We previously covered Realty Income (NYSE:O) in May 2023, rating the stock as a Buy, thanks to its CPI-tied rental escalators and consistent dividend payouts. The management had also raised its FY2023 AFFO guidance, potentially triggering an expanded full-year dividend payout, due to its historical payout ratio of ~75%.
For now, O has delivered another excellent FQ2’23 earnings call, with revenues of $1.02B (+8% QoQ/ +25.9% YoY) and AFFO per share of $1.02 (-1.9% QoQ/ in line YoY).
This is on top of the REIT’s raised FY2023 guidance of AFFO per share range to between $4.07 and $4.15, compared to the FQ1’23 guidance range of between $4.05 and $4.15, and FQ4’22 guidance range of between $4.01 and $4.03.
However, it appears that Mr. Market is not convinced about O’s execution thus far, as witnessed by the massive pessimism embedded in its stock valuations and prices.
O 5Y EV/Revenue and Price/ AFFO Per Share Valuations
For example, O is currently trading at an NTM EV/ Revenues of 15.13x and NTM Price/ AFFO Per Share of 13.85x, moderated compared to its 1Y mean of 16.20x/ 15.72x and 3Y pre-pandemic mean of 18.72x/ 19.13x.
Based on its impacted valuations and the consensus FY2025 AFFO estimates of $4.45, we are looking at a long-term price target of $61.63, suggesting a minimal upside potential from current levels.
However, we believe the pessimism has been overdone, since O is expected to grow its AFFO per share at a CAGR of +3.3% through FY2025, compared to the pre-pandemic levels of +4.9%, though moderated compared to the hyper-pandemic levels of +5.7%.
O 5Y Stock Price
The O stock has also returned much of its July 2023 gains, despite the excellent FQ2’23 performance and raised FY2023 guidance, likely attributed to the mixed prospects surrounding the recent shares offering.
On the one hand, with the REIT’s long-term shareholders already diluted to 674.59M of shares outstanding by the latest quarter (+2% QoQ/ +12% YoY), we may see a further dilutive effect on its forward AFFO per share and dividends, depending on when the additional sale is exercised.
On the other hand, due to the elevated interest rate environment, we believe that the management has chosen to go with a low cost capital to sustain its high growth cadence, instead of turning to expensive financing.
While O’s FQ2’23 long-term debts of $19.58B (+4.3% QoQ/ +30.7% YoY) may be drastically elevated compared to its FY2019 levels of $7.67B (+18% YoY), we may see this number stabilize as a result of the capital raise.
However, while market analysts may have priced in a rate freeze in the upcoming FOMC meeting in September 2023, it is undeniable that the REIT also reported an eye-watering annualized FQ2’23 interest expense of $735.44M (+19.2% QoQ/ +66.9% YoY).
Much of this is attributed to the increasing weighted average interest rate of 5.6% for its revolving credit facility (+0.2 points QoQ/ +3.4 YoY) and 5.4% for its commercial paper programs (+2.3 points QoQ/ +1.8 YoY) in the latest quarter. This is on top of the rising interest rate for its long-term debts to 3.6% (+0.2 points QoQ/ +0.4 YoY), with an average maturity of 6.7 years (-0.1 QoQ/ -0.9 YoY).
Combined with the increased depreciation/ amortization of $472.27M (+4.6% QoQ/ +15.3% YoY) and to a smaller extent, the property expenses of $94.7M (+36.4% QoQ/ +81.4% YoY), O’s total expenses have rose drastically to $817.82M (+13% QoQ/ +32.7% YoY) by the latest quarter.
These costs naturally impacted the REIT’s FFO generation to $687.99M (inline QoQ/ +13% YoY), negating the sustained growth in its top-line.
O has also made ambitious investments of $4.8B YTD (+50% YoY), with an initial weighted average cash lease yield of 6.9% (+1.2 points YoY). However, as discussed above, the higher yield has also been negated by the elevated interest environment, momentarily triggering the pullback in its stock valuations and prices.
Investors must also note that the management has further raised the FY2023 acquisition target to over $7B, up from the FQ1’23 levels $6B and FQ4’22 levels of $5B, likely funded by the recently announced capital sale.
Therefore, depending on when the Fed pivots, we believe O may continue to face profitability headwinds, with its next dividend raise likely being minimal by +$0.0005 to $0.2560 in the next month.
So, Is O Stock A Buy, Sell, or Hold?
Therefore, while we may continue to rate O as a Buy here, due to its expanded forward dividend yield of 5.45%, compared to its 4Y average of 4.36% and sector median of 4.99%, the stock is only suitable for investors with higher risk tolerance and long-term investing trajectory.
With the REIT stock continually underperforming the wider market, it remains to be seen if its forward dividend payouts may be able to negate the declining stock value thus far, otherwise known as, dividend trap.
On our side, we will be monitoring the price action for a little longer and may start a small position if the stock’s critical support level of $55 is not breached over the next two weeks. Only time may tell.