Phillips Edison: Limited Catalysts, Shares Fairly Valued (NASDAQ:PECO)

Phillips Edison (NASDAQ:PECO), owner and operator of grocery-anchored shopping centers, turned in another record quarter in Q2. The records were attained in both leased rates and renewal spreads. The latter is being sustained by ferocious demand for their property class. New rent spreads, for example, are being completed at over 20% rates.

In my prior update on the stock, I provided coverage on PECO’s first quarter results. And similar to Q2, the company turned in record results on leased rates. The forward outlook was also viewed to be favorable. However, I viewed the stock as fairly valued, especially given where shares traded in relation to the peer set.

Given another quarter of record results, I wanted to take a closer look at the potential catalysts. While the portfolio has exhibited strength, the marginal benefit of further improvement appears limited. In addition to the lack of internal growth opportunities, the external transactional market has been muted. The lack of meaningful immediate catalysts, therefore, are likely to keep shares rangebound.

PECO Key Portfolio Metrics

At June 30, PECO owned 274 shopping centers across 31 states leased primarily to grocery-anchored neighborhood shopping centers; more specifically, those with the #1 or #2 position in sales in their respective markets. 86.5% of annualized base rents (“ABR”) were derived from such tenants.

The total leased rate at period end was 97.8%, with anchors at 99.4% and their inline spaces at 94.8%. Retention rates were also high at 93.8%, with anchors at 100%.

PECO Q2 Results

Even though operating expenses grew 7.1%, PECO still reported YOY growth in same-center net operating income (“NOI”) of 5.3%. Margins were also in line at 72.4%. This compares to 72.7% in the same period last year.

During the quarter, PECO executed 1.6 MSF of leases at a weighted average lease term (“WALT”) of 5.3 years and at blended spreads of 11.5%, in-line with their average over the past twelve months.

Most of the leasing activity was centered around their option leases, which represented 901 MSF of their quarterly activity. On these, PECO realized spreads of 4.2%. In contrast, they realized spreads of 25.1% and 17.7% on their new and renewal signings, respectively.

Overall, PECO reported core funds from operations (“FFO”) of $0.59/share, an 8.2% increase over the same period last year. On an adjusted basis, stripping out recurring capital expenditures, quarterly FFO was approximately $0.47/share.

Takeaways From PECO’s Recent Performance

It was another record quarter following records just set in Q1. Leased rates in Q1, for example, increased to a record 97.5%. It then increased 30bps sequentially to a new record of 97.8%, with their inline rate also hitting a new record of 94.8%. The occupancy gains came while PECO was driving rents at spreads of over 25% on new signings and at new records for their renewals. Though overall retention dipped slightly to 94%, it remained just shy of the 95% record attained in Q1.

The record results enabled an increase in the full-year guidance. PECO now sees core FFO at a midpoint of $2.33/share, up from $2.31/share previously. Currently, the company is paying out a monthly dividend of $0.0933/share, representing an annual payout of approximately $1.12/share or just 48% of expected core FFO. The dividend, therefore, appears well covered.

The positive revisions to core FFO were driven mostly from the positive outlook on same-store NOI growth, which is now forecasted at a midpoint of 4.125%, up significantly from the prior midpoint of 3.5%.

While all has been mostly positive, the potential for further internal growth appears limited. As the sequential increase from Q1 to Q2 showed, PECO proved that their leasing team can build on leased rates. But the current record rate of 97.8% does warrant the question of the marginal benefit of further increases. Anchor rates are already at 99.4%. So, any further gains in leased rates will need to be from their inline portfolio. And here, CEO, Jeffrey Edison, pointed to 50 to 150bps of potential opportunity.

Though positive, would it be enough to move the needle on the stock? Since my last update in June, where I covered their Q1 results, shares have gained 4.3%, beating out the S&P’s 2.3% gain over the same period. Given the record-setting quarter at the time, the gains could have arguably been higher.

Developments are another large factor for internal growth. And on this, the management team reduced guidance quite notably. The new midpoint stands at +$40M, down +$15M from the prior midpoint. PECO President, Devin Murphy, attributed this decline to factors such as entitlement and material delays, as well as to tenant-related considerations. Their high retention rate of 94%, though positive, also has the effect of delaying accretive capital-related work on their properties.

Is PECO Stock A Buy, Sell, Or Hold?

I view PECO as a “hold” at current trading levels. From an internal perspective, there appears to be limited capacity for further growth in leased rates. Their leased and economic occupancy rates are also in-line with one another, suggesting minimal tailwinds from pending commencements. The development outlook also appears challenged, given higher retention rates and regulatory/tenant-specific considerations.

The lack of opportunity from an internal perspective is also paired with the lack of external activity. Guidance is calling for +$250M in acquisitions at the midpoint. But PECO has completed just +$72M through the first half of the year. Jeff Edison did provide the disclosure that they may likely end up at the low end of their range. That would still be about +$200M, however. It’s hard to see PECO achieving their projected target, especially since it was noted that cap rates are still adjusting in response to the higher rate environment.

PECO will likely face few, if any, hurdles acquiring properties from a financial perspective. The company generates over +$100M in free cash flow after dividends. And they operate on a moderate debt load of 5.2x, with +$800M available to them on their revolver. They have a higher degree of floating rate exposure, at nearly 20% of their stack, but this hasn’t particularly weighed on their operating results.

The question is not whether PECO has the financial capacity to acquire properties. It’s instead whether the opportunities present themselves. Given the muted activity through the first half of the year and the general strength in the sector, I am less optimistic that these opportunities will arise. The lack of opportunity will keep shares in a holding pattern, in my view.

For investors seeking positioning, PECO is a solid candidate to follow in the sector. But its upside potential from here appears limited due to limited immediate catalysts.