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STORE Capital: The Fastest-Growing Company in Warren Buffett's Portfolio

Investment thesis

STORE Capital Corp. (NYSE:STOR) reported year-over-year revenue growth of 23.9% in 2018, making it the fastest-growing holding in Warren Buffett (Trades, Portfolio)'s portfolio. Surprisingly, this real estate investment trust was able to grow at a faster rate than e-commerce giant Amazon.com Inc. (NASDAQ:AMZN).


Source: Data from company filings

Because STORE Capital is structured as a REIT, it distributes most of its earnings to shareholders as dividends. At the current market price of $37.57, shares yield 3.5%.

Company overview and the business model

STORE Capital is a net-lease REIT that acquires and manages a portfolio of single-tenant operational real estate properties. The company has been in business for more than 30 years. At present, it operates 2,389 properties, leased to 456 customers, spread across 50 states in the U.S.

STORE Capital's focus is on the services sector, which is evident from the high number of tenants representing this sector.

Source: Data from company filings.

High exposure to the services sector is a good sign for investors, as the retail and manufacturing sectors are cyclical and suffer significant losses during economic downturns.

The business model is unique in that the portfolio consists of profit-center real estate assets. This means that tenants make rental contracts senior to other financial obligations as the tenants' profitability depends on the ability to operate these profit center assets.

The business-to-business sales approach helps the company make better contracts with tenants. Per Securities and Exchange Commission filings, approximately 80% of the company's new business is brought in through this sales channel.

Portfolio quality

The latest company filings indicate year-over-year revenue growth of tenants at the end of the second quarter was 15.1%. Cumulatively, these tenants have added more than 300,000 employees in the last 12 months, indicating their financial strength.

The majority of companies renting properties from STORE Capital earn at least $50 million in revenue per annum. Even though the company operates in the U.S. middle market, management takes additional care to work with companies that are generating sufficient income to service lease payments.

Source: Investor presentation.

The contribution from the top tenant to the company's revenue was 2.6% in the second quarter, and 80% of tenants each contributed less than 1% to revenue. The portfolio is highly diversified as it is spread across 50 states in the U.S. and includes tenants from over 100 industries. This makes STORE Capital resilient to economic downturns that may be occurring in particular sectors.

The top 10 customers accounted for only 17.7% of base rent and interest in the last quarter, which is another indication of the well-diversified nature of the investment portfolio.

Source: Data from company filings.

Fundamentals

STORE Capital completed its initial public offering in 2014. Since then, revenue has grown in each financial year, indicating the quality of the asset portfolio. Favorable macroeconomic conditions, such as robust growth in the U.S., also played a part in its success story.

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The occupancy level, which is a critical consideration in evaluating the quality of a REIT's business operations, has been 99% or better over the last five years. This is an indication that the demand for STORE Capital's assets is high and that assets are in prime locations.

Source: Data from company filings.

The company's balance sheet is strong, and there is no imminent threat from a liquidity perspective.

The majority of debt maturities are scheduled for beyond 2023, which reduces the company's refinancing risk in the short term. Management is positive debt repayments can be covered using free cash flow.

Source: Company filings.

Growth opportunities

The target market of STORE Capital is the U.S. middle market, and the focus is on the services sector. According to the World Economic Forum, this target market has nearly 200,000 companies, providing ample opportunities for STORE Capital to identify good companies and bring them on as tenants.

STORE Capital plans to achieve growth from two fronts - internal and external growth.

In the second-quarter earnings presentation, management confirmed it expects adjusted funds from operations per share will grow 5.25% annually.

Source: Second-quarter earnings presentation.

External growth will come from property acquisitions. According to company filings, at the end of the second quarter, STORE Capital's pipeline was worth over $12 billion, which is an indication of the value of properties that will be added to the portfolio in the future. The pipeline has grown consistently since 2012.

Source: Company filings.

To fund the acquisition of properties represented by this pipeline, the company plans to use a few financing options. Issuing equity is one of the primary sources of funding for STORE Capital. The REIT has over $525 million available under a credit facility as well, which also has an $800 million accordion feature. These financing options will be sufficient to complete its pipeline projects planned for the next fiscal year.

STORE Capital pays close attention to the business operations of potential tenants before signing a contract. In the age of e-commerce, some retailers have come under tremendous pressure to stay relevant. A classic example is the failure of Sears Holdings Corp. Management evaluates the company's online presence, in-store digital experience and the availability of loyalty programs before onboarding new tenants. This extensive screening process helps STORE Capital rent its properties to high-quality companies that are expected to grow with the developing macroeconomic trends.

Dividend

STORE Capital increased its dividend distribution by 32% between 2014 and 2018. The table below provides a summary of dividend hikes since 2015.

Year

Increase in dividends

2015

8%

2016

7.4%

2017

6.9%

2018

6.5%



Source: Data from company filings.

For dividend investors, the safety of the dividend matters as much as growth. STORE Capital has been covering its annual distributions with funds from operations consistently, which is an indication of dividend safety.

Management plans to distribute around 70% of funds from operations to investors and retain the remaining 30%. This strategy will ensure the safety of the dividend in the future as well.

STORE Capital's earnings can be expected to grow along with the success of planned acquisitions and favorable lease rate negotiations, which in turn will lead to future dividend hikes. The company has an attractive profile for dividend growth investors.

Valuation

A two-stage dividend discount model was used to derive the intrinsic value of STORE Capital, as distributing cash to shareholders is a primary use of the company's earnings.

The consensus estimate is for revenue to grow 22.6% in 2019. The below table provides a detailed projection for revenue.

Fiscal year

Revenue estimate (millions)

The implied year-over-year growth rate

2019

$660.07

22.06%

2010

$746.97

13.17%

2021

$837.19

12.08%

2022

$955.45

14.13%

2023

$1,006

11.32%



Source: Refinitiv Eikon.

This projected revenue growth will result in an increase in funds from operations as well, which is a crucial estimate in determining dividend growth for the next five years.

Fiscal year

Funds from operations per share estimate

2019

$1.90

2020

$2.03

2021

$2.16

2022

$2.33

2023

$2.46



Source: Consensus estimates and the author's projections.

The target funds from operations payout ratio is 70% according to management. A range of 70% to 75% was used to calculate the intrinsic value.

A perpetual growth rate of 2.5% was used to calculate the terminal value, and all the cash flows were discounted at the cost of capital estimate of 7%.

Using these inputs, the intrinsic value of STORE Capital comes to $41.75 per share. This represents an upside of 11% from the current market price, which provides an acceptable margin of safety for income investors.

Source: Author's calculations on Finbox.

The intrinsic value is highly sensitive to the cost of capital estimate and the terminal growth rate. For instance, if the cost of capital increases 50 basis points to 7.5%, the fair value declines from $41.75 to $37.54. On the other hand, a terminal growth rate reduction of the same magnitude results in a fair value estimate of $38.08.

The quality of management

Investing in a REIT requires paying attention to the experience and quality of the management team. At the 1994 Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) annual shareholders meeting, Warren Buffett (Trades, Portfolio) described two ways to assess this.

The first method is to evaluate the relative performance of the company:


"I think you judge management by two yardsticks. One is how well they run the business, and I think you can learn a lot about that by reading about both what they've accomplished and what their competitors have accomplished and seeing how they have allocated capital over time. Look at what they have accomplished, considering what the hand was that they were dealt when they took over compared to what is going on in the industry."



The second is to look at how management has treated shareholders in the past:


"You want to figure out how well that they treat their owners. Read the proxy statements, see what they think of -- see how they treat themselves versus how they treat the shareholders. The poor managers also turn out to be the ones that really don't think that much about the shareholders, too. The two often go hand in hand."



STORE Capital stands out from its peers. Over the last five years, the REIT's revenue growth outpaced that of its peer group.

Source: Koyfin.

In addition, the company's compounded annual growth rate of net income during this period was superior to that of its peers.

Company

Compounded revenue growth (5 years)

STORE Capital

44%

Realty Income Corp

10.6%

Simon Property Group

9.9%

W.P. Carey & Co. Llc

12.8%

Ventas Inc

0.6%



Source: Data from Eikon.

The management team has executed a commendable growth strategy for revenue and earnings at better than industry rates and has complemented this with shareholder-friendly policies. The best indication of a management team's shareholder friendliness is the dividend policy. As STORE Capital has been consistent in distributing earnings to shareholders and plans to do so in the future, it can be concluded the interests of the REIT's managers line up with those of its shareholders.

The high-quality management team in another reason income investors should consider investing in STORE Capital.

Conclusion

STORE Capital is a REIT trading below its intrinsic value and shares yield 3.5% at the current market price. Growth will come both internally and externally as the company reinvests its retained earnings and completes acquisitions in its pipeline. Even though the real estate sector is cyclical, the company's focus on tenants in the services sector that can withstand economic downturns adds a degree of certainty for expected cash flows. STORE Capital is a buy.

Disclosure: I do not own any stocks mentioned in this article.

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