Phillips Edison & Company, Inc. (NASDAQ:PECO) Q3 2023 Earnings Call Transcript

Phillips Edison & Company, Inc. (NASDAQ:PECO) Q3 2023 Earnings Call Transcript November 1, 2023

Operator: Good day, and welcome to Phillips Edison & Company’s Third Quarter 2023 Earnings Conference Call. Please note that this call is being recorded. I will now turn the conference over to Kimberly Green, Head of Investor Relations. Kimberly, you may begin.

Kimberly Green: Thank you, operator. I am joined on this call by our Chairman and Chief Executive Officer, Jeff Edison; our President, Devin Murphy; and our Chief Financial Officer, John Caulfield. Once we conclude our prepared remarks, we will open the call to Q&A. After today’s call, an archived version will be published on our website. As a reminder, today’s discussion may contain forward-looking statements about the Company’s view of future business and financial performance, including forward earnings guidance and future market conditions. These are based on management’s current beliefs and expectations and are subject to various risks and uncertainties as described in our SEC filings, specifically in our most recent Form 10-K and 10-Q.

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In our discussion today, we will reference certain non-GAAP financial measures. Information regarding our use of these measures and reconciliations of these measures to our GAAP results are available in our earnings press release and supplemental information packet, which have been posted on our website. Please note that we have also posted a presentation with additional information. Our caution on forward-looking statements also applies to these materials. Now, I would like to turn the call over to Jeff Edison, our Chief Executive Officer. Jeff?

Jeff Edison: Thank you, Kim, and thank you, everyone, for joining us today. The PECO team delivered another solid quarter of growth with same-center NOI increasing by 3.2% and continued strength in portfolio occupancy and rent spreads. This performance has allowed us to reaffirm the midpoint and tighten the range of our 2023 core FFO guidance. The midpoint represents year-over-year growth of 2.6 %, despite interest expense headwinds of $0.10 per share. We believe we will continue to deliver positive earnings growth despite interest expense and other macro headwinds. The continued strength of our operating performance is attributable to our differentiated and focused strategy of exclusively owning grocery-anchored neighborhood shopping centers anchored by the number one or two grocer by sales in a market, and our ability to drive results at the property level through our integrated and cycle-tested operating platform.

Today, we see a continued strong operating environment, and a transaction market that has improved. The consumer continues to be resilient and our grocers continue to drive strong foot traffic to our centers. We remain 98% occupied, which gives us pricing power. Leasing demand continues to be elevated for our inline spaces, and we have limited exposure to big-box retailers. We have a great balance sheet and are well-positioned for accretive acquisitions. We have seen an increase in deal activity beginning in third quarter as cap rates continue to adjust in response to higher interest rates. Based on our current pipeline, we have increased the low-end of our guidance range for acquisitions. While it’s still a market in transition, we are confident in our ability to close on $250 million to $300 million in net acquisitions this year.

We continue to have a very-disciplined acquisition process. We remain focused on accretively growing our shopping center portfolio at the right price, while achieving our acquisition hurdle of a 9% unlevered IRR. The acquisitions that we will complete in the second half of the year underwrite to a 9.5%-plus unlevered IRR. With PECO’s experienced in-house acquisition team, we are well-positioned to continue to grow our portfolio. The PECO team looks forward to sharing an update on our acquisition strategy, including case studies, our underwriting process and our targets for 2024, during our Investment Community Day on December 14th. In September, Kroger announced the divestiture plan with C&S Wholesale Grocers in connection with the proposed Kroger and Albertsons merger.

We remain cautiously optimistic about the impact on PECO. We continue to believe, it is ultimately a positive for PECO, for our centers and for the communities that our centers serve. While the market still gives the merger a low probability of occurring, should it close and 413 stores are sold to C&S, the impact on PECO is a net positive. C&S has been operating for over 100 years, and they are one of the largest wholesale operators with demonstrated experience in retail operations. We believe the recent announcement is potentially a better outcome for PECO than a new SpinCo that Kroger and Albertsons had considered. Importantly, should the merger occur, the majority of our Albertsons stores will be operated by an excellent operator in Kroger.

If the merger does not occur, our Albertsons anchored centers will continue the strong performance that they have enjoyed to-date. I will now turn the call over to Devin. Devin?

Devin Murphy: Thank you, Jeff. Good afternoon, everyone. And thank you for joining us. Our leasing team continues to convert strong retailer demand into higher occupancy with higher rents at our neighborhood shopping centers. Anchor occupancy ended the quarter at 99.3% leased, representing a year-over-year increase of 40 basis points. Inline occupancy increased 10 basis points sequentially to 94.9%, representing a year-over-year increase of 130 basis points. We believe there is still upside in our inline occupancy, given the continued strong demand for space. As of September 30th, in-place ABR per square feet for our inline neighbors increased 5.2%, compared to a year ago. We continue to capitalize on strong renewal demand, and are making the most of the opportunity to strengthen key lease terms and drive renewal rents higher.

Specifically, for the third quarter we achieved a 16.9% increase in renewal rent spreads. In terms of new lease activity, we continue to have success in driving meaningfully higher rents. New rent spreads for the third quarter increase 26.3%. We expect that leasing spreads will continue to be strong through the balance of this year and into the foreseeable future. PECO’s retention rate remains strong this quarter as well at 93%. An important benefit of high retention rates is that we have much lower TI spend on renewals. In Q3, we spent less than a $1 per square foot on TI for renewals. The exact amount was $0.88 per square foot. On average, our new and renewal inline leases executed in Q3 had annual contractual rent bumps of 2.5%, an important contributor to our long-term growth rate.

The leasing spreads that we are achieving combined with our strong retention rates are clear evidence of the continued high demand for space and our grocery-anchored centers. Our continued pricing power is a reflection of the strength of our strategy and the quality of our portfolio. During our upcoming investor day, you will hear from our operations team leaders on how the PECO team delivers growth at the property level and why we remain confident in our ability to deliver long-term same center NOI growth of 3% to 4% on an annual basis. The team will be prepared to share insights on why our assets are successful, our strategic locations and suburban markets, our right size format, and the other advantages we enjoy in the markets where we operate.

Turning to redevelopment and development. We continue to invest in our value-creating roundup outparcel development and redevelopment projects, which remain an excellent use of our free cash flow and deliver very attractive returns. Year-to-date, we have stabilized 10 projects, delivering over 223,000 square feet of space to our neighbors with incremental NOI of approximately $2.9 million annually. These projects provide superior risk-adjusted returns and have a meaningful impact on our long-term NOI growth. For the full year 2023, we continue to expect to invest $35 million to $45 million in ground up outparcel development and redevelopment opportunities with rated average cash on cash yields on this activity between 9% and 12%. During our upcoming investor day, the PECO team will provide an update on our pipeline of ground up development and redevelopment projects across our portfolio.

PECO continues to benefit from a number of positive macroeconomic trends that create strong tailwinds and drive strong neighbor demand for us. These trends include a resilient consumer, hybrid work, migration to the Sunbelt, population shifts that favor suburban communities and the importance of physical locations and last mile delivery. The impact of these demand factors are further amplified due to limited new supply being created over the last 10 years and going forward, given that current economic returns do not justify new construction. In summary, our differentiated strategy continues to position PECO well for continued steady growth in all economic cycles. This is due to our exclusive grocery-anchored focus on centers anchored by the one or two grocer in a market, our necessity-based neighbor mix, our right size format, our well-positioned locations in growing suburban markets, our high-occupancy with continued strong neighbor demand for space, our high-leasing spreads and retention rates, our well-diversified neighbor mix, our lack of exposure to distressed retailers, our strong balance sheet and most importantly, our well-aligned and cycle tested team.

I’d now like to turn the call over to John. John?

John Caulfield: Thank you, Devin, and good morning and good afternoon everyone. I’ll start by addressing third quarter results, then provide an update on the balance sheet, and finally, speak to our updated 2023 guidance. Third quarter 2023 Nareit FFO increased 70 basis points to $72.5 million, or $0.55 per diluted share, driven by an increase in rental income from our strong property operations. Results were partially offset by higher year-over-year interest expense of $4 million as well as a one-time non-cash impairment charge of $3 million related to a third-party investment. Third quarter core FFO increased 50 basis points to $77 million or $0.58 per diluted share, driven by increased revenue at our properties from higher occupancy levels and strong leasing spreads partially offset by higher interest expense.

During the quarter, we acquired Lake Point Market, a grocery anchored center in the Dallas Texas suburbs for $12.9 million. We expect to drive growth by increasing occupancy and enhancing merchandising mix in addition to the potential for development of outparcels. In addition, we purchased a land parcel adjacent to the marketplace at Pabst Farms located in a Milwaukee, Wisconsin suburb. We expect to drive growth through expansion development opportunities. Subsequent to quarter-end, we acquired one property and one outparcel. Mansell Village, an 89,600 square foot shopping center is anchored by Kroger in an Atlanta, Georgia suburb. We expect to drive growth in the asset through occupancy increases and rent growth. As of October 31st, PECO is under contract to acquire additional assets that are expected to close during the fourth quarter of 2023.

This will bring our net acquisition volume for the year to between $250 million and $300 million. In the third quarter, PECO issued approximately 2 million shares under our ATM facility, which resulted in net proceeds of $70.1 million. Our gross weighted average share price was $35.59. Assets acquired year-to-date and currently in our pipeline are accretive to earnings per share at these levels. We were intentional in match funding these acquisitions with equity at a time when our access to the equity market was favorable, while keeping our leverage low. In addition to the recent term loan extensions, this issuance delays our need to go to the long-term debt market, which we believe is currently unfavorable. From a balance sheet perspective, we ended the quarter with approximately $714 million of liquidity, including cash and capacity on our $800 million credit facility.

Our leverage ratio continues to decrease as a result of our strong earnings growth and our equity issuance with our net debt to adjusted EBITDA at 4.9 times as of September 30, 2023. Our debt had a weighted-average interest rate of 4.1% and a weighted average maturity of 4.4 years when including extension options. 82% of our debt was fixed rate. As we look at our floating rate debt exposure, our long-term target is to limit our floating rate debt to less than 10% of our total debt. We are currently in an unusual environment, given the inverted yield curve, wider spreads, and other factors, which is why we are exercising more patience before locking in long-term rates. Our lack of near-term maturities provides us with flexibility to be patient.

That said, we remain focused on all options to meet our long-term target as soon as possible. Between the free cash flow generated by our portfolio and the significant capacity available on our revolver, we remain confident in our ability to successfully fund our growth plans. Turning to guidance. We’ve updated our Nareit FFO and core FFO per share guidance. Primarily due to a one-time non-cash impairment charge related to a third-party investment, we have lowered our Nareit FFO guidance to a range $2.23 per share to $2.27 per share. We have reaffirmed the midpoint of core FFO guidance and tightened the range to $2.31 per share to $2.35 per share. As Jeff mentioned, the midpoint represents year-over-year growth of 2.6%, despite interest expense headwinds of $0.10 per share.

We also reaffirmed our same-center NOI guidance in the range of 3.75% to 4.5%. Importantly, despite the impact of higher interest rates and other macro headwinds, we are delivering earnings growth due to the continued strong performance of our portfolio, driven by leasing spreads, occupancy and high retention. We plan to provide preliminary guidance for 2024 and update on our long-term growth drivers during our upcoming investor day. With that, I’ll turn it back to Jeff. Jeff?

Jeff Edison: Thanks John. Before we get to your questions, I’d like to acknowledge the press release we issued yesterday announcing changes to PECO’s leadership team. Devin will step down as President on December 31st. At that time, Bob Myers, currently COO, will become President and Joe Schlosser, currently Head of Portfolio Management, will become Chief Operating Officer and an Executive Vice President. This is the culmination of our long-standing succession plan. I would like to extend our sincere gratitude to Devin, who has worked side by side with me to transform PECO into one of the largest owners and operators of grocer anchored neighborhood shopping centers in the country. Bob and Joe are extremely talented, proven leaders and team players, who have been critical to the consistent strength of our operating performance.

They have played an important role throughout the majority of PECO’s 30-year history, growing the portfolio into what exists today. Bob and Joe have been with PECO for over 20 and 19 years, respectively. They have successfully managed operations, development, acquisitions and dispositions through multiple cycles. I am confident, they will continue to scale the portfolio from here, and I look forward to continuing to partner with them in delivering long-term growth and value creation. Devin will serve as a Managing Director of Investment Management through his planned retirement at the end of June. During this time, he will work closely with me and the team to ensure a seamless handoff of his current responsibilities. Devin is also in discussions with the nominating and governance committee about joining PECO’s Board of Directors following his retirement.

I would also like to highlight the recent appointment of Tony Terry to serve as an independent Director of PECO’s Board, effective October 30th. We’re delighted to welcome Tony to the Board. With more than three decades of public company business experience, working with senior management and boards to drive growth and innovation, Tony brings a proven track record of strategic planning, corporate and operational finance, regulatory matters, and capital allocation. We’re excited to have Tony on our Board. With that, we look forward to your questions. Operator?

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Q&A Session

Operator: [Operator Instructions] We’ll take our first question from Caitlin Burrows at Goldman Sachs.

Caitlin Burrows: Maybe to the topic of the floating rate debt exposure. You guys mentioned the long-term goal of under 10% floating rate. And then, you also mentioned that the equity issuance during 3Q was to match fund acquisitions. I know, you don’t have meaningful debt maturities in ‘24, but there are interest rate swaps expiring and other floating rate debt out there. So I’m just wondering if you can comment on kind of your ability, and then separately the willingness to use equity to reduce that floating rate debt.

Jeff Edison: Thanks Caitlin for the question. John, do you want to take that question?

John Caulfield: Sure. Good morning, Caitlin. So, at the end of the quarter, we were 82% fixed rate on our debt and higher interest rates are certainly a headwind. We’re estimating that for this full year it’ll be about $0.10 impact on our — as a headwind, but we continue to have positive core FFO growth for the year. So with this uncertainty in the environment, we are taking the position to float more of our debt than the 10% floating rate target. And we do believe that the long-term debt market continues to be unsettled as spreads are wide given the volatile treasury environment and things going on in the macro. And we do want to be a long-term issuer, and we do have that long-term target of 10%. But we think accessing those longer-term fixed rate instruments would be more appropriate when there’s more stability in the market and liquidity in the capital markets.

So I think that the piece for us when it comes to issuing debt and equity, it’s really — it matches with our acquisitions. And so, as we look at the acquisitions that we have upcoming as well as those we made, when we looked at the equity that we were — and where we were raising that price, we know that it’s accretive to earnings. And that was important to us. So, I think it’s going to be a combination of both that we can — we’re able to borrow accretively with the acquisitions and the same with raising equity. So, I think it’ll be both, but it’ll depend on that availability. I mean, overall, our leverage of 4.9 times, and as you say, no meaningful maturities for about 24 months, gives us that flexibility to be patient. And so in this market that is — you’ll see us float more than we otherwise typically would.

Caitlin Burrows: Got it. Okay. But it doesn’t sound like you’re necessarily looking — or maybe the option is open to use equity to address some of that near term.

Jeff Edison: Yes. I was going to say that, exactly.

John Caulfield: Yes.

Caitlin Burrows: Yes. Got it. Okay. And then maybe just turning to acquisitions in order to make the guidance range that guys put out with the updated range, it seems like there’s either a lot of properties or some larger deal that you’re expecting to happen in the fourth quarter. So, I’m just wondering if you can comment on the types of properties you’re seeing for sale and then which are most attractive to PECO at this time?

Jeff Edison: Yes. Well, there’s no major transaction. These are multiple transactions with multiple sellers. Consistent with our existing strategy and — as you know, we’ve been cautious the last several quarters on the acquisition side. And a lot of these deals are deals that have worked through during that longer period of time with price concessions and a variety of different tools that we’ve had to get these to where they made sense for us. And we feel really positive about the projects and we think that they’re sort of fairway in terms of fitting with our core strategy. And I think we’re — when we underwrote them and got to sort of a mid-9s plus in terms of an unlevered IRR, we felt that they — we were being sort of risk rewarded for being active in a market that is, as you know, very fluid right now.

And one of the things that got us comfortable with it was, when you looked at the price per foot we were paying, it was under $260 a foot, which really for us is going to continue to give us really strong pricing power in these particular markets to be able to really drive growth and be able to grow our earnings from these particular properties. So, we’re very excited about the properties we’ve got under control and as we said, we feel comfortable we’ll be in that 250 to 300 range.

Caitlin Burrows: Just one quick thing. You mentioned there, Jeff, price concession. By that, do you mean that — over the course of the discussions, the seller was willing to settle on a lower price to get it done?

Jeff Edison: I mean, I think, in this environment you’ve got to have sellers who are eyes open to the market and what’s changing with in this interest rate environment. And so, I think that getting a seller who is realistic about where the market is today, one of the more important things in the acquisition process and continues to be front of mind for us to make sure that we’re not wasting our time, we’re actually spending on things. And fortunately, these deals have worked through.

Operator: We’ll go next to Jeff Spector at Bank of America.

Jeff Spector: First congratulations to Devin, Bob and Joe. Follow-up question to — on acquisitions, did I miss it, Jeff? Did you discuss the cap rate range? I heard you say an IRR 9% plus, but anything on kind of cap rates?

Jeff Edison: I think, the way I would look at it is, we’ve seen in our view — I mean, first of all, you know that we’re really not cap rate underwriters, we’re unlevered IRR underwriters. But if you do sort of translate that back and you say there’s been a 100 to 150 basis points movement in cap rates, I would say that we’re seeing that in the marketplace today. We’re not seeing a huge volume, but we are seeing that in the market today.

Jeff Spector: Okay. And I know these are — things are hard to forecast. But it feels like then things are improving a bit, since we last saw you. And you said the transaction market, it is improving. I guess, do you think that things will open up even more in ’24? Again, those conversations are improving with the sellers or, again, ’24 is just uncertain at this point?

Jeff Edison: I would say uncertain at this point. I mean, there continues to be a big beta in terms of acquisition volume. We are trying to give you guys as much direction as we can, but it’s a difficult environment. And it is a really tough environment when you are moving to really what is a much more of a buyer’s market than a seller’s market, and we’ve all been through those transitions. They take a long time and they are difficult. And so, you — these are the times you got to be more disciplined than ever in your underwriting and in your patience to get to where you think the right pricing is. So, I wouldn’t look at ’24. I hope we will give you some more clarity at our investor meeting in December. But it is choppy.

Each deal has a story to it today. And that means it’s going to be — I think you are going to — it’s going to be a choppy environment. But I would say that, generally, we are optimistic that we’ll have a decent backlog going into next year. So, we’ll be in a decent position going forward.

Jeff Spector: Thanks, Jeff. And then just my last question. Devin, you talked about still improving inline occupancy or increasing that, I assume, next year, the following year. At the same time, I mean, we are seeing, and John talked about macro headwinds, the more retailers reporting misses, more concerns over the consumer going forward. How are you balancing, I guess, the leasing decision? Are these more local tenants, regional, national? Like, what are you doing as the environment is — it does seem to be changing here with the consumer. You have been doing this a long time. So, how do you know change the leasing strategy or do you not?