Phillips Edison & Company, Inc. (NASDAQ:PECO) Q4 2023 Earnings Call Transcript

Phillips Edison & Company, Inc. (NASDAQ:PECO) Q4 2023 Earnings Call Transcript February 9, 2024

Phillips Edison & Company, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good day, and welcome to Phillips Edison & Company’s Fourth Quarter and Full-Year 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’m joined on this call by our Chairman and Chief Executive Officer, Jeff Edison; our President, Bob Myers; our Chief Financial Officer, John Caulfield; and our Managing Director of Investment Management, Devin Murphy. Once we conclude our prepared remarks, we will open the call to Q&A. After today’s call, an archived version will be published on our website.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.

In our discussion today, we’ll 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 to 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’d 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 in 2023 continued our track record of delivering strong growth. Same center NOI increased 4.2%, the Nareit FFO increased 6.7% and core FFO increased 5.2%. The continued strong performance of our portfolio is driven by our high occupancy, strong leasing spreads, high retention, and the many advantages of the suburban markets where we operate our neighborhood shopping centers. The operating environment remains strong with a resilient consumer. Retailers want to be located in our centers, where our grocers drive consistent and recurring foot traffic. PECO continues to benefit from several positive macroeconomic trends that create demand for space and tailwinds for NOI growth.

The transaction market also improved for us in the latter part of 2023, allowing us to exceed the midpoint of our original guidance for acquisitions. The capital markets have improved. Interest rates have meaningfully changed from when we provided preliminary 2024 guidance during our Investor Day in early December. These factors allow us to increase our 2024 guidance. We accomplished a great deal in 2023 and have a lot to be proud of. At the macroeconomic level, the year presented many challenges with high inflation, volatile and rising interest rates, and global conflict. However, the consistency of our growth is a testament to our differentiated and focused strategy of exclusively owning right-sized, gross-rankered neighborhood shopping centers, anchored by the number one or two grocer by sales in a market.

Our results at the property level are driven by our integrated operating platform and our experienced and cycle-tested team. We could not have accomplished our 2023 results without the hard work of our PECO associates. I’d like to thank the entire PECO team for all of their efforts. PECO has always been a growth company and we are well-positioned to continue to grow. The fourth quarter was no exception with $186 million in acquisitions. For the full year 2023, we acquired 11 shopping centers, two outparcels, and one land parcel for net acquisitions totaling $272 million at a weighted average cap rate of 6.6%. We are particularly excited to add two more Trader Joe’s anchored centers and another H-E-B anchored center to our portfolio. The transaction market was tight in 2023, as the bid-ask spreads were very wide.

Our team has proven its ability to navigate and successfully execute through these tough markets. This result is due to our scale, our ability to buy in many markets across the country, our reputation as a sophisticated all-cash buyer, and our strong relationships. We’re confident in our ability to continue to acquire high-quality centers as the transaction market opens up further. While it’s early, we continue to successfully find attractive acquisition opportunities. Activity in the first quarter remains strong. Our ability to predict acquisition volume for the rest of the year is less clear. As such, we are reaffirming our guidance for $200 million to $300 million of net acquisitions. We have the capabilities and leverage capacity to acquire much more if attractive opportunities materialize.

We continue to target an unlevered IRR of 9% or greater for our acquisitions. The acquisitions that we completed in the second half of 2023 underwrote to over 9.5% on levered IRR. We will maintain our disciplined approach and focus on accretively growing our portfolio. We are hopeful that volumes will increase through the year. It is times like this in an evolving market that we have historically found some of our best opportunities. With the target market of 5,800 identified centers across the U.S., we have a long runway for external growth. Looking beyond 2024 and assuming a more stable interest rate environment and acquisition market, we believe our portfolio can deliver mid-to-high-single-digit core FFO per share growth on a long-term basis.

This will be driven by both internal and external growth. We are confident in our ability to sustain growth in the near term despite interest expense headwinds. We anticipate long-term AFFO will be higher than core FFO growth as high occupancy and strong retention should require lower capital expenditures to support growth in the future. Our low leverage gives us the financial capacity to meet our long-term growth objectives. We expect to generate approximately $100 million in free cash flow after dividend distributions in 2024. This level of free cash flow combined with our low levered balance sheet, allows us to acquire $250 million a year with — while maintaining our targeted leverage ratio without raising any additional equity. PECO continues to be well-positioned to drive strong earnings growth and achieve our capital deployment goals in the years ahead.

We remain committed to successfully executing our growth strategies, both internal and external. PECO generates more alpha with less beta given our focused and differentiated strategy. As previously announced by Kroger and Albertsons, the estimated closing date for the proposed merger was recently pushed back. We do remain cautiously optimistic about the impact of this merger 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, we believe the impact on PECO is a net positive. Our Albertson stores will be operated by Kroger, which we invest regularly in their stores and produces higher sales volumes.

If the merger does not occur, our Albertsons’ anchored centers will continue the strong performance that they have produced to date. With that, I’ll now turn the call over to our new President, Bob Myers, to provide more color on the operating environment. Bob?

Bob Myers: Thank you, Jeff, good afternoon, everyone, and thank you for joining us. We continue to see strong retailer demand with no current signs of slowing. PECO’s leasing team continues to convert this demand into higher rents at our centers. Portfolio occupancy remained strong and ended the year at 97.4% leased. Anchor occupancy remained high at 98.9%. Inline occupancy ended the year at 94.7%, an increase of 90 basis points year-over-year. We believe that we can still push inline occupancy another 100 basis points to 150 basis points given continued strong retailer demand. Our acquisitions in the fourth quarter were 84% leased at closing and provide significant leasing opportunities. Buying centers with some vacancy will continue to allow us to drive growth.

In terms of new lease activity, we continue to have success in driving meaningfully higher rents. Comparable new rent spreads for the fourth quarter were 21.9%. We continue to capitalize on strong renewal demand and are making the most of the opportunity to strengthen key lease terms at renewal and drive rents higher. In the fourth quarter, we achieved a 14.2% increase in comparable renewal rent spreads. This increase in renewal spreads is consistent with the 14.6% increase we achieved in 2022 and reflects the continued strength of the leasing environment. Our inline renewal spreads remained high at 17.4% in the fourth quarter, which compares to our trailing 12-month average of 17.7%. We expect leasing spreads will continue to be strong throughout the balance of this year and into the foreseeable future.

We continue to have great success retaining our neighbors while growing rents at attractive rates. PECO’s retention rate remains strong this quarter at 93%. An important benefit of high retention rates is that we have much lower TI spend on renewals and in the fourth quarter we spent $1.17 per square foot on tenant improvements for renewals. We also remain successful at driving higher contractual rent increases. Our new and renewal inline leases executed in 2023 had an average annual contractual rent bumps of 2% and 3%, respectively, another important contributor to our long-term growth. The leasing spreads that we are achieving combined with our strong retention rates create pricing power and are clear evidence of the continued high demand for space in our grocery-anchored neighborhood shopping centers.

PECO’s pricing power is a reflection of the strength of our focus strategy and the quality of our portfolio. PECO continues to benefit from a number of positive macroeconomic trends that create strong tailwinds and drive strong neighbor demand. These trends include a resilient consumer, hybrid work, migration to the sunbelt, population shifts that favor suburban neighborhoods, and the importance of physical locations in the last-mile delivery. The impact of these demand factors are further amplified due to the limited new supply over the last tenures, and going forward, given the current economic returns do not justify new construction. We continue to see the many benefits of our grocery-anchored portfolio with a healthy mix of national, regional, and local retailers.

70% of our rents come from neighbors offering necessity-based goods and services, and our top grocers continue to drive strong reoccurring foot traffic to our centers. PECO’s 3-Mile trade area demographics include an average population of 66,000 people and an average median household income of $80,000, which is higher than the U.S. median. These demographics are in line with store demographics of Kroger and Publix, which are PECO’s top two neighbors. Our centers are situated in trade areas where our top grocers are profitable and our neighbors are successful. We also enjoy a well-diversified neighbor base. Our top neighbor list is comprised of the best grocers in the country. Our largest non-grocer neighbor makes up only 1.3% of our rents and that neighbor is T.J. Maxx.

All other non-grocer neighbors are below 1% of ABR. To put a finer point on neighbor mix, PECO has no exposure to luxury retail and very limited exposure to distressed retailers. The top 10 neighbors currently on our watch list represent just 2.3% of ABR. 27% of our ABR is derived from local neighbors. The majority of local neighbor rents come from retailers offering necessity-based goods and services. If you think about your favorite restaurant in your neighborhood, your physical therapist, chiropractor or dentist, and your preferred hair salon or barber, there is a high likelihood that they are a local retailer. Our local neighbors are successful businesses run by hardworking entrepreneurs. They have healthy credit and are less susceptible to corporate bankruptcy caused by weaker-performing locations.

Local neighbors offer favorable economic returns. A typical local retailer receives less capital at the beginning of their lease, accepts more PECO-friendly lease terms, has high retention rates, and achieves renewal spreads similar to nationals. PECO retained 85% of local neighbors in the fourth quarter, and for inline local neighbors, renewal rent spreads remained strong at 17% in the fourth quarter. Importantly, local retailers meaningfully differentiate the merchandise mix that our neighborhood centers offer our customers. Our local neighbors are resilient and have been in our shopping centers for 9.4 years on average. In addition to our strong rental growth trends, we continue to expand our pipeline of ground-up outparcel development and repositioning projects.

In 2023, we stabilized 13 projects and delivered over 230,000 square feet of space to our neighbors. These projects add incremental NOI of approximately $3.4 million annually. These projects provide superior risk-adjusted returns and have a meaningful impact on our long-term NOI growth. We continue to expect to invest $40 million to $50 million annually in ground-up development and repositioning opportunities with a weighted average cash-on-cash yields between 9% and 12%. This activity remains a great use of free cash flow and produces attractive returns with less risk. We continue to make great progress on these properties and our team is working hard on growing this pipeline. In summary, the PECO team remains optimistic about the current strong operating environment and the continued positive momentum we are experiencing across leasing, redevelopment, and development.

In addition, our healthy neighbor mix and grocery-anchored strategy positions PECO well for continued steady growth. The overall demand environment, the strength of our centers, the strength of our grocers, and the capabilities of our team give us confidence in our ability to continue to deliver strong operating results. I will now turn the call over to John. John?

John Caulfield: Thank you, Bob, and good morning and good afternoon, everyone. I’ll start by addressing the fourth quarter results, then provide an update on the balance sheet, and finally speak to our increased 2024 guidance. Fourth quarter 2023 Nareit FFO increased 6% to $74.8 million or $0.56 per diluted share, driven by an increase in rental income from our strong property operations. Results were partially impacted by higher year-over-year interest expense of $4.3 million. Fourth quarter core FFO increased 4.9% to $77.9 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 the aforementioned higher interest expense.

Our same-center NOI growth in the quarter was 3.6%, driven by minimum rent growth of 3.8% year-over-year. Our reserves for uncollectability were slightly elevated in the quarter at 97 basis points. However, they were below the fourth quarter of 2022. We do see an upward trend in reserves in the fourth quarter each year. We monitor the health of our neighbors closely and are not concerned about bad debt in the near term, particularly given the strong retailer demand that shows no signs of slowing. During the fourth quarter, we acquired six grocery-anchored shopping centers and two outparcels for a total of $186.4 million. We had no dispositions during the quarter. In the fourth quarter, PECO issued 2.2 million shares under our ATM facility, which resulted in net proceeds of $77.5 million at a weighted average gross price of $35.92 per share.

For the full year, PECO generated net proceeds of $147.6 million through the issuance of 4.2 million common shares at a weighted average gross price of $35.76 per share. Assets acquired in 2023 and currently in our pipeline are accretive to earnings per share at these levels. We were intentional in match funding our acquisitions with equity at a time when our access to the equity market was favorable while keeping our leverage low. We will continue to evaluate future equity issuance based on a combination of favorable market conditions, acquisition opportunities, and identifying uses of proceeds that are earnings accretive. Turning to the balance sheet, we have approximately $615 million of liquidity to support our acquisition plans with no meaningful maturities until late 2025.

Our net debt to adjusted EBITDAre was at 5.1 times as of December 31, 2023. Our debt had a weighted average interest rate of 4.2% and a weighted average maturity of 4.1 years when including all extension options. Subsequent to quarter end, we entered into an interest rate swap agreement totaling $150 million, the new instrument swap SOFR to approximately 3.45% effective September 25, 2024, and matures December 31, 2025. This swap will help us manage our floating rate exposure as we have swaps that expire in September and October of 2024. With the execution of this swap and a decrease in the forward rate curve for SOFR, we are revising our 2024 interest expense estimate lower and our FFO estimates higher. In January, S&P revised its ratings outlook for PECO to positive from stable.

While favorable, we continue to believe we are an underrated credit at BBB- Baa3 and remain focused on achieving a ratings upgrade. We continue to meet with the agencies as we believe our financial strategies are commensurate with at least a BBB flat or Baa2 rating. Although we cannot specify when an upgrade will occur, we continue to target leverage levels to achieve this goal, which we believe to be approximately 5.5 times. We ended the year at 78% fixed rate debt with 22% floating. Several of our peers accessed the unsecured bond market in January. We continue to monitor this market and look to access it opportunistically. Although we have no meaningful maturities until November 2025, we will consider opportunities to enhance our liquidity and extend our debt maturity profile.

Between the significant free cash flow generated by our portfolio and the capacity available on a revolver, we can be strategic in our timing when accessing the debt market. That leads me to our guidance for 2024 and our ability to increase it from the preliminary guidance shared at our Investment Community Day in early December. Our updated net income per share range for 2024 is $0.53 to $0.58 per share. Our increased range for Nareit FFO per share is $2.34 to $2.41, which is a 6% increase over 2023 at the midpoint of the range. Our increased range for core FFO per share is $2.37 to $2.45, which is a 3% increase over 2023 at the midpoint. We are reaffirming our range for same-center NOI growth of 3.25% to 4.25% given the continued strong operating environment.

Included in our guidance is the negative impact of normalizing our anticipated uncollectible reserves to historical levels of 60 basis points to 80 basis points of revenue. We are reaffirming the range previously provided given the continued strong health of our neighbors. As of February 8, we have several acquisitions in our pipeline, either under contract or in contract negotiation. This activity provides a strong start for the year. As Jeff mentioned, it is still early so we are reaffirming our acquisition guidance and expect net volume to be in a range of $200 million to $300 million. If the transaction and capital markets improve, we are hopeful and have the capacity to meaningfully increase this number, but we are comfortable with this guidance range in the current environment.

As we outlined at our Investment Community Day, we believe the internal and external growth opportunities for PECO give us a long-term growth outlook in the mid-to-high-single-digits for core FFO per share growth. We expect a comparable or faster growth rate for AFFO per share because there should be less tenant improvement dollars required as occupancy stabilizes. In the near term, we are impacted by interest rate increases as all borrowers are, which is limiting our earnings growth. However, we are pleased to guide to positive per share growth. For 2024, we are updating the range of interest rate expense to $95 million to $105 million. Our decreased guidance range is primarily due to PECO having a lower revolver balance at the end of the year, which was driven by our equity issuance in December combined with a lower projection for the SOFR curve.

While not eliminated, these revisions do lessen the earnings headwind for interest expense, we estimate that higher interest rates could be a headwind of $0.04 to $0.10 for the year. If we add it back, the per share impact of interest rate variance to our updated 2024 guidance, this would be 6% Core FFO growth at the midpoint. 2023 presented many challenges with high inflation, volatile and rising interest rates, and global conflict, however, we were able to exceed our 2023 earnings guidance due to the focus and commitment of PECO’s experienced team and the strength of our integrated operating platform. We are excited for the growth opportunities ahead in 2024, both internal and through acquisitions. With that, we will open the line for questions.

Operator?

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question comes from the line of Caitlin Burrows with Goldman Sachs. Please go ahead.

Caitlin Burrows: Hi, I guess, good afternoon, everyone. In the earnings release as it relates to guidance, you guys pretty clearly show the assumptions driving guidance, and like John, you just mentioned, the interest expense was brought down, which I think on a per share basis would be like $0.06, but the midpoint of guidance only increased by $0.01, so I was wondering if you could talk a little bit about what may have made you only increase the midpoint of the core FFO range by $0.01 rather than $0.06. Thanks.

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

John Caulfield: Sure. Thanks, Caitlin. So, yes, if you look at the interest rate expense component of our guidance, at the midpoint it decreased $0.06, but $0.04 of that was because of the equity issuance that we did in the fourth quarter. So the net is actually — the interest expense benefit to guidance would be $0.02 and we were happy to increase our guidance range by a penny at the midpoint. And so I think you could also look at it and say it’s early in the year, but there’s opportunity for future growth in our earnings than what’s presented.

Caitlin Burrows: So, are you saying that part of it is related to, like the underlying leverage and share count assumption then too?

John Caulfield: That’s correct. So the interest expense went down because we had a lower revolver balance at the end of the year, because of the equities — because there’s more share count. And so the net between — interest is lower, but the share count would be higher. So it’s about $0.06 and it’s about $0.04 as the impact from the additional shares, so that leaves the $0.02.

Caitlin Burrows: Okay, got it. And then, you guys laid out in the Investor Day how you could achieve 3% to 4% same-store NOI growth even without further occupancy growth. I guess to take the other side of that, with occupancy so high, what do you think is the risk that occupancy declines, I guess, this year or in the future? And I guess, yes, how likely is it, and what would the impact be?

Jeff Edison: Caitlin, the — one thing that I don’t think we really mentioned at Investor Day is that — one of the things that we’ve been doing on the acquisition side is to look for opportunities where there’s less occupancy than what we have in our core portfolio and to lease that space up to give additional growth. And if you look at, from a quarter basis, it gets complicated based upon when we buy what and what kind of occupancy, because we’re at such a high level of occupancy across the portfolio. So I do think that if you look at, I mean — I think it was 84% occupied, the projects that we bought, that’s going to consistently be a drag separate from what the same store portfolio occupancy would be. And Bob, I don’t know if you have anything to add to that.

Bob Myers: Yes, Jeff, the only thing I would add to that is when you look at how we come up with 3% to 4% same-center NOI growth, we said at the Investor Day, we’d have 100 basis points to 125 basis points coming from new and renewal spreads, 75 basis points to 100 basis points in contractual rent bumps, 75 basis points to 125 basis points coming from Redev and our development projects, but we acquired net $272 million, and overall, we — 14 assets totaled 87% occupied, and in the fourth quarter it was 84%. So that’s going to allow us to continue to drive future growth. So we’re excited with those projects.

Caitlin Burrows: Yes, no, that definitely makes sense in being able to lease up the acquisition properties. I guess, as you think about those pieces of the same-store NOI growth, I guess occupancy up or down isn’t assumed, so I’m wondering, what’s the risk occupancy in the same-store portfolio comes down?

Jeff Edison: I feel right now that we still have another 100 basis points to 150 basis points of occupancy left in our inline spaces. I believe right now we’re at 94.7%, so we still feel like there’s another 150 basis points in our existing portfolio on the same-center basis of occupancy movement. And we continue to see significant demand for the spaces that we have.

Caitlin Burrows: Okay, so it sounds like you would think there’s more upside potential versus downside?

Jeff Edison: For sure, absolutely.

Caitlin Burrows: Okay. Thank you.

Jeff Edison: Thanks, Caitlin.

Operator: Your next question is from the line of Tayo Okusanya with Deutsche Bank. Please go ahead. Tayo, your line is open, please go ahead.

Tayo Okusanya: Hello?

Operator: Yes, we can hear you. Please go ahead.

Tayo Okusanya: Perfect. On the acquisition front and with the acquisition guidance, could you give us a sense if it’s going to be more front-weighted, back-weighted even throughout the year, and give us kind of a general sense of what kind of cap rates you’re expecting on transactions?

Jeff Edison: Sure. Tayo, thanks for the question. As you know, acquisitions are bumpy. Last year was probably a difficult year on the acquisition side as we’ve had and probably bumpier than any previous year that we had. I would assume it will be bumpy this year too. And I think we’ve got good belief that we’re going to get into our guidance in terms of when we do have decent activity for the first quarter. But I would — again, it’s hard to say exactly when that will happen. To be conservative, I would say it’s going be — there’ll be more in the back end, but we’ve had a couple of good weeks of new acquisition opportunities coming in, so that could be a little less back-ended. Certainly, we hope it’ll be less back-ended than last year.

But I — as we’ve said, we feel good about our guidance. We’re cautious about timing and how that will fall out. And in terms of cap rates, as you know, we’re IRR buyers and we continue to underwrite to nine plus unlevered IRR. In the — last year, that translated into like a 6.6 cap rate. I would assume similar visibility into this year. Again, trying to create additional growth opportunity through some of the properties we buy and our ability to expand them and expand the cash flow from them.

Tayo Okusanya: Got it. Thank you.

Jeff Edison: Yes, thanks, Tayo.

Operator: Your next question is from the line of Lizzy Doykan with Bank of America. Please go ahead.

Lizzy Doykan: Hi, thanks. Maybe like a similar question, but just on redevelopment, just curious if there’s more clarity on the timing of spend there throughout 2024 as I know that tends to be lumpy.

Jeff Edison: Yes. Thanks for the question, Lizzy. Bob, do you want to take sort of that and maybe John as well?

Bob Myers: Sure, John, I’ll go ahead and start. I think when I look at the pipeline this year, we are still thinking that we’ll do between $40 million and $50 million, and a lot of those projects, just to remind everybody, I mean, these are smaller projects that are $2 million, $3 million in size. They are 4,000 to 5,000, 6,000 square feet in our parking lots and all our existing shopping centers. So we’ll end up doing somewhere between 12 and 15 projects with targeted returns between nine and 12. Timing is tricky, and as Jeff mentioned with the acquisitions, the same is true, especially when you’re doing tear down rebuilds. We’re currently doing two tear down rebuilds with Publix and a lot of that has to do with their timing. So it’s always going to be a bit in flux. So it’s kind of hard to navigate quarter by quarter. But as I look at it on an annual basis, I would feel comfortable that our guidance of $40 million to $50 million is in range that we can hit.

Lizzy Doykan: Okay, great.

John Caulfield: I was going to say, Lizzy, to add to that, our assumptions as we look at it, it is fairly — even with a slight weighting towards the second half of the year, but as Bob said, it’s pretty even throughout, but if I had to nudge, it’d be a little bit more on the back.

Lizzy Doykan: Understand. Thanks. And then, maybe following up on Caitlin’s question from before, just on occupancy as it relates to same-store NOI, it really sounds like that there’s no downside scenario to occupancy being factored in. And I’m just curious if maybe you could help us understand the areas of uncertainty that there may be to same-store NOI or that if this past year and this year is a function of just a really strong environment. If you could provide more color on, maybe it’s the nature of your portfolio, limited exposure to big box, or if it’s the geography kind of explaining the characteristics there would be helpful.