NNN REIT Inc (NNN) 2006 Q3 法說會逐字稿

Greetings, ladies and gentlemen, and welcome to the National Retail Properties Inc. third-quarter of 2006 earnings conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (OPERATOR INSTRUCTIONS) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Mr. Craig Macnab, Chief Executive Officer. Thank you, sir. You may begin.

Diego, thank you. Good morning and welcome to our third-quarter 2006 earnings release call. Also on this call is Kevin Habicht, our Chief Financial Officer, who will review details of our third-quarter financial results after brief operating comments from me.

We're extremely pleased with our financial performance in the third quarter, which continues to track ahead of plan. We had an active quarter and I will highlight in a moment several of the key events since we last spoke to you. However, we are delighted to have generated FFO of $0.46 per share from operations.

Our portfolio continues to be in excellent shape, with occupancy of 98.2%. The high level of occupancy is attributable to the quality of our fully diversified net lease retail portfolio. As a reminder, we currently own 691 properties which are leased to 183 different tenants in 45 states and it is this type of breadth which gives us confidence in describing this portfolio as fully diversified.

In terms of the portfolio, we congratulate our largest individual tenant, Susser Holdings, on their recent successful initial public offering. The significantly improved credit profile of Susser validates the confidence that our underwriting team placed on this well-managed company when we purchased $170 million of their properties in December 2004.

In the most recent quarter, we acquired 89 properties for $131 million for our investment portfolio at a weighted average cap rate of just over 8.75%.

Of note in this quarter was the acquisition of a Denny's portfolio right at the end of the quarter. This was an interesting transaction as these are mature restaurants many of which have been operating for more than 25 years and they are generally located in high barrier to entry markets. Our analysis of these properties is that the price that we paid is considerably less than the replacement cost of this real estate and that view by the way has been confirmed by a recent appraisal which was performed by and for other parties.

This is particularly interesting as there are a couple of leases that mature in the next couple of years and we may have some opportunities there to move rents up. By the way, the average remaining lease term of this particular portfolio is ten years, which is generally less than what we normally acquire.

In terms of property type, you're going to see us continue to be active in the restaurant space, which is the largest single category in the net leased retail segment. By the way, we have two experienced acquisition officers on our team who both spent many years working in the real estate area for major brand-name restaurant chains. For the nine months ended September 30, we have acquired 175 carefully underwritten individual retail sites for $267 million at a weighted average yield of approximately 8.75%.

Our acquisition activity thus far this year is in excess of the annual goal of acquisitions that we established at the beginning of this year. In addition, we have a healthy pipeline of acquisitions teed up for the next 90 days, although some of these will undoubtedly only close in early 2007.

In our earnings release comments exactly one year ago, we started talking about capital recycling and this year we have certainly walked the talk. We have sold just over $265 million of properties from our investment portfolio this year, including about $20 million of properties in the most recent quarter. For the next several quarters you'll see us continue to recycle capital, although the quarterly pace will be more in line with the most recent quarter in 2007. In this current quarter here, the fourth quarter of 2006, we will be a little bit more active than we were in the most recent quarter in terms of capital recycle.

Just as a reminder, the key objectives of our capital recycling program are firstly to manage our portfolio quality and concentration amongst large tenants. Secondly, we are selling capital lease properties where we can. And more importantly, we are reinvesting the proceeds from selling these assets in higher yielding, well underwritten retail properties, ideally where the lease structure contains some element of growth.

From a capital markets perspective, we have been active in the last couple of months, raising about $265 million of capital. Kevin will provide further details on a couple of key points worth noting. We have essentially replaced all of our floating-rate debt with fixed-rate debt at this point in time. Secondly, with the 7 3/8 preferred that we have recently issued, we have pre-financed the 9% preferred that we can redeem at the end of December. And then of course, our balance sheet is in very good shape with debt to total market cap of about [40]%.

In summary, we are having what we characterize as a successful and productive 2006. Our portfolio is in excellent shape. We have a healthy acquisition pipeline. Our balance sheet, particularly following the October preferred offering, is very strong. We are clearly pleased with the growth in FFO which we have achieved this year and we are optimistic about the way that NNN is positioned to continue to grow our FFO per share in 2007.

I will now hand over to Kevin.

Thanks Craig. Let me start with the customary cautionary note that we will make certain statements that have been considered to be forward-looking statements under Federal Security Laws. The Company's actual future results may differ significantly from the matters discussed in any forward-looking statements. We may not release revisions to these forward-looking statements to reflect changes after these statements have been made. Factors and risks that could cause actual results to differ materially from expectations are disclosed from time to time in greater detail in the Company's filings with the SEC and in this morning's press release.

With that, as indicated in the press release, we reported third quarter FFO results totaling $21.9 million or $0.38 per share. For the nine months 2006 results were $1.21, representing a 6.1% increase over prior year results. Also noted in the press release excluding a non-cash valuation impairment on our mortgage residual interest, more about which in a moment, FFO for the third quarter '06 would've been $0.46 per share, as Craig indicated.

We are pleased with these improved results and notably the results for 2006 and even as we look into 2007, are being driven by a variety of factors from accretive acquisitions, lower capital costs, leasing G&A, recycling capital, just a variety of things that are driving higher results.

In today's release, we also announced increased FFO guidance for 2006, increasing FFO per share guidance to $1.64 to $1.66 per share. That is up from the $1.62 to $1.66 range previously given. Compared to 2005 $1.54 per share results, this represents a 7.1% growth in FFO per share to the midpoint guidance for '06.

Primary assumptions used in this guidance include core portfolio acquisitions for the fourth quarter of '06 that could range from $50 million $100 million; core portfolio dispositions of $20 million to $50 million; we now see G&A expense coming in that $25.5 million for the year; mortgage residual interest income is expected to come in at $1.3 million in the fourth quarter; and pretax TRF gains on sale are projected to be $3.5 million to $5.5 million for the quarter.

In our press release this morning, we also introduced 2007 guidance of $1.74 to $1.80 per share. This represents 7.2% growth from the midpoint '06 to midpoint '07 guidance. At this time, we are projecting a stronger second half '07 compared to first half 2007.

The primary assumptions in this guidance are $200 million to $220 million of core portfolio acquisitions, investments; $18 million of core portfolio dispositions; G&A expense of $24 million; mortgage residual interest income of $4 million; and pretax gains on sales from our TRS properties of $12 million. We believe the visibility is fairly good on this guidance, but as always the projections are based on a number of factors and uncertainties, as discussed in our public filings.

Let me go through some of the details for the third quarter and then we will take some questions. Looking at the income statement, we reported total revenues for the third quarter of $38 million. The increase from third quarter '05 driven largely by increased investments made over the last year and the rent associated with those investments. I do want to add and point out that we have added some additional disclosure on page 5 of the press release regarding contingent rents, straight line rents, and capital lease earned income for your information. I won't go through on the call here.

Acquisitions in the core portfolio, as Craig mentioned, totaled $131.3 million in the third quarter. Occupancies stood at 98.2%, which is down 20 basis points from the immediately prior quarter. Interest income and other income from real estate transaction that consists primarily of mortgage and mezzanine loan income and some miscellaneous items. The $842,000 decrease to $665,000 in the third quarter was primarily the results of a payoff of a $24.3 mezz loan in April of '06. At the end of quarter, we had $7.7 million outstanding in our structured mezzanine loan investments.

Interest income from mortgage residuals was $1.7 million in the third quarter, which is down from $1.9 million in the prior quarter and down from $2.8 million last year. The decrease is a result of scheduled amortization of loans as well as accelerated prepayment speeds associated with those loans.

G&A expense for the quarter came in at $4.7 million. That is down from $6.4 million last year. Large of this decrease was timing related and incentive compensation. There was some lower debt yield costs; however, we are currently expecting G&A to total $25.5 million versus our higher guidance earlier for '06.

Property expenses net of tenant reimbursements were fairly flat with the prior year amounts for the quarter and the nine months. During the third quarter of '06, this past quarter, as you would note, we did book a $6.1 million impairment charge related to the mortgage residual assets. As you recall, we in May of 2005 invested $9.4 million to acquire a 78.9% interest in Orange Avenue Mortgage Investments and that entity owns a static pool, commercial mortgage residual assets and these residuals are experiencing above-average prepayment speeds right now. And the valuation used in marking these assets to market as we do every quarter increased the future prepayment speed assumption, which reduces the carrying value of the residuals and produced the impairment.

This quarter's impairment was partially offset by accelerated amortization of deferred tax liability on Orange Avenue's books and that added about $1.381 million of income tax benefit to our third quarter results. So the net impact of these two items after the minority interest was about a negative $3.7 million. That is taking a $6.1 million impairment charge, less the $1.380 million of tax benefit and backing out the minority interest gets you can a net negative of $3.7 million. For the nine months 2006, the net impact after minority interest was the same $3.7 million.

We have again included some additional detail on Orange Avenue's results in our press release. As we've talked about, while this investment has created some accounting noise that can be distracting and make projections a little more difficult, since we invested $9.4 million in May of 2005, this entity has produced over $15 million of net cash flow for us. That is just NNN's share. Time will tell precisely how it all works out, but we believe this has been a very good investment.

Going forward, the increase in prepayment speed assumptions that we embedded in the valuation this past quarter will mitigate any future impairments due to accelerated loan prepayments.

Moving on, in the third quarter we received $1.5 million of lease termination fees; $1.27 million of that was reported in the discontinued ops and $275,000 in continuing ops. By comparison we only had $68,000 of lease termination fees in the third quarter of '05.

In other expenses and revenues, interest and other income increased to $836,000. That is up $349,000 from prior year amounts largely due to higher cash balances and higher interest rates on those balances.

Looking at interest expense for the third quarter, increased to $12.1 million. That's up from $8.8 million in 2005 and up somewhat from $11.2 million in the prior quarter. The $3.3 million increase from last year's third quarter is primarily a result of higher outstanding debt balances and higher short-term interest rates. At quarter end we had $99.6 million of our $871.7 million of total liabilities with floating-rate debt, so that's 11.4% of our debt total liabilities was floating-rate. However as a percent of gross book assets which I believe is more meaningful it was 5.2%.

We also reported the sale of five properties in the third quarter from our core investment portfolio and those are reflected in the discontinued ops investment portfolio section. These sales generated proceeds of $20.3 million and produced a gain of $4.1 million.

Discontinued operations inventory properties -- these are properties held in our TRS, we sold a total of 18 properties from our taxable subsidiary, one of which was a land parcel sold out of our development unit producing a $108,000 gain; 17 were from our 1031 exchange unit, which were mostly convenience stores. For the quarter, total pretax pre overhead expense gain on sale from our TRS was $507,000.

With our active acquisition pace we've had a good amount of inventory held for sale in our TRS which we are actively marketing. The market for the disposition of properties we've developed or acquired for sale continues to be robust. As we talked about before, there will be choppiness in the reported gain on sale number from quarter-to-quarter depending on the timing of those sales.

Moving to the balance sheet, finished the third quarter with total liabilities of $871.7 million. Of this amount, $63 million was secured debt; 94% of our total assets are unencumbered. As we previously announced, and Craig mentioned, we issued $172.5 million of 3.95% convertible notes at par. The notes are convertible into NNN shares at $24.45 per share but there are a number of provisions that restrict conversion, require the par being settled in cash, the par value being settled in cash and provide a put after year five. So the way we view this particular security is really as a five-year fixed-rate debt with some potential modest dilution if converted.

Additionally during the quarter we issued 606,000 shares of common stock from our stock purchase [DRIP] program which generated $12.5 million of equity proceeds. Also subsequent to quarter end, as Craig mentioned, we issued $92 million of straight preferred with a 7 3/8% coupon. We intend to use approximately $45 million of those proceeds to redeem our 9% series A preferred which becomes redeemable after 12/31 '06.

As of quarter end, 9/30 '06, total debt to total assets was 45.4% on a gross book basis. That is up a little bit from 42.6% the prior quarter, but down from 49.2% at year-end '05. On a market cap basis, our leverage was 39.9%.

Interest coverage was 3.3 times for the third quarter and 3.1 times for the nine months '06. Fixed charge coverage was 3.0 for the quarter and 2.8 for the nine months '06.

In closing, we are very pleased with the projected FFO per share growth of 7% for both '06 and '07 and particularly pleased that it's being driven by a variety of factors from accretive acquisitions, lower capital costs, squeezing G&A, recycling capital, a variety of things which all are driving higher results. We believe the portfolio and balance sheet are in very good shape and are optimistic we will be able to deliver incremental per share results as we continue to create value through targeted acquisitions, dispositions and development.

With that, I will turn it back to you, Craig.

Diego, we would like to open it up for any questions please.

(OPERATOR INSTRUCTIONS) Jonathan Litt, Citigroup.

Hi, this is (indiscernible) with John. On the Danny's sale, you had mentioned that there were leases expiring in near future. Are you expecting to release the properties before the tenant leaves or do you expect [income] vacancy?

The first choice would be to renew the property with the existing tenant at a higher lease than they have been playing on the primary term of their existing lease, which is almost 20 years old. And I think we're going to have pretty good success in that, however it is a three-party transaction. Denny's would have to renew the franchise to the operator and we would need to enter into a new lease agreement. However the key point, though, is that these properties are generally in barrier to entry locations. A fair number of them out on the West Coast and we think the value of the dirt is worth a lot of money in many of these locations.

Okay, and related to Orange Avenue, do you have future impairments assumed in 2006 and 2007 guidance?

No, we think the valuation impairment that we took in the third quarter '06 increased the assumed prepayment speeds not only for currently but into the future, so we're hopeful obviously that that's addressed -- this issue. So we have not assumed any further impairments there going forward. There could be, but it is not assumed in our guidance.

Okay. And can you give you give a sense of the size of your acquisition pipeline and some color on is it big deals, small deals, and then the cap rates?

The environment is very good right now. We are clearly seeing many different types of companies looking at taking multiunit retail operators private. I think we all saw this morning a significant announcement for Outback Steak House and we are looking at a variety of transactions including A, bigger deals. But we are also continuing to build our acquisition pipeline one store at a time.

In our current pipeline of transactions which we're expecting to close in the next, say, 120 days, it is interesting how many different tenants are in that pipeline, which says that there are lots of one by one deals as well as -- many of those are follow-ons from existing relationships that we have established over the last couple of years where a growing retailer continues to expand their business and they are coming to us for their sale leaseback transactions. In addition of course we are looking at bigger transactions.

In response to your question about the pricing, I think that so far this year we've done a very good job of identifying transactions which have cap rates consistent with the guidance we provided and were looking for of 8.75%. I think next year we might look at or we are currently looking at a couple of transactions which will push that number down a little bit -- pick a number --8.5%.

Okay, thank you. Just one last question. Just to clarify, there was a $1.5 million lease term fee and discontinued ops?

Yes, there was a lease term fee of a total of $1.5 million. $1.270 million was in discontinued ops and $275,000 was in continuing operations.

Where in continuing ops was that?

It would be in rent.

Okay, thank you.

David Fick, Stifel Nicolaus.

Actually most of my questions were just asked. I would focus a little bit more if you could on where you might be looking geographically and at what property type in terms of the active pipeline right now?

The property type I mentioned in the prepared remarks is we're going to be doing more in the restaurant category. We already have pretty good exposure to that. But our current pipeline includes more restaurant transactions than we entered into in the first nine months of this year. We have clearly built a very good presence, name recognition, and a knowledge base in the convenience store category and some of the tenants that we are currently working with the relationships we've established are continuing to grow there for companies and we will see more business in the convenience store category.

Geographically for better or for worse, we are located in the Sunbelt and we are very fortunate with that. We have got a healthy presence in Sunbelt states, Texas, Florida, Arizona, Georgia, Carolinas, and we are seeing acquisitions all over the country.

Okay, and I guess my last question is on Orange. You've got about a $32 million book basis now. Is that correct?

Correct, in residuals and Orange Avenue's balance sheet, correct.

Okay, and stepping aside from the accounting right now, which is a little obtuse, can you kind of walk us through the economics of how that business is going to wrap up in the timeframe? What is real here and what should we be thinking about how to value it?

It is very real. Like I said, we've invested $9 million in that investment and received about $15 million back already. What's going to happen going forward is this is a static pool of residual interest and we are just working off that loan pool. And so as quickly as that loan pool amortizes, our investment and our return will amortize as well over that same time period. If I had to guess, it is probably in the two- to five-year range in terms of winding that down, so that is a very static activity. We are a passive investor there. The clock has been wound and it is just ticking off.

At the into the day it will be a very good return for us. We have -- did convert this entity to a REIT and so that has saved a meaningful amount of taxes obviously for this entity and are amortizing that tax liability. Lastly on the balance sheet, there is a large amount of restricted cash that you are seeing and that is in connection with the business operations that was sold in December 2004. And that cash gets released in December of '07. So that is another piece of value that will accrue to us later next year.

I don't mean to come across as not understanding the accounting, but I don't completely. This impairment is not an economic loss?

That's correct. It was a non-cash valuation impairment. Just to remind folks, it is driven by the prepayment speeds underlying these loans and depending on those loan speeds you mark down or mark up the value of these assets. Given the shape of the yield curve, which is fairly abnormally flat for an extended period time here, it's creating an environment which prepayment speeds have accelerated.

You won't object to us taking this out of the numbers we report to First Call then?

No, we think they are good numbers.

Okay, thank you.

(OPERATOR INSTRUCTIONS) Ken Avalos, Raymond James.

My question was just on the Denny's portfolio and the appraisal that you said was done outside by another party. Did you run your own appraisal and was there a significant delta between those two?

There was not. On our team is a qualified appraiser but in our underwriting group, we present each and every property and put together our own analysis of types of metrics you would expect including replacement costs and so forth. I did want to -- I just made that little comment that the appraisal was done by a third party or other people that we did not commission that. We did have an ability to take a look at it, but it just validates it is third-party validation that the value of the properties that we purchased is perhaps worth more than we paid.

But either way, this is a very good transaction for us. There is actually some upside over the next couple of years. There is a little bit of percentage rent in this portfolio. I'm pleased to say with Denny's currently growing sales at 3% to 4%, there will be a little more percentage rent in the future.

Thanks, that's all I had. Nice job.

Let me just for a moment respond to something that Dave Fick was talking about. The Orange Avenue, that impairment is non-cash and it is driven by accounting. It is unfortunate that it occurred in a quarter where our operations were extremely strong; however, it is the reality that we have to live under.

Let me just add one other tweak to that note. If you go back to 2005, you'll also see in a different environment these residuals were valued more highly and we actually booked a $15 million extraordinary gain associated with this investment. So there has been accounting noise on both sides of the equation over the last year and a half. But once you parse through it all, it has been a very good investment for us.

There are further questions at this time. I will now turn the conference back over to you to conclude.

Thank you very much. We appreciate your interest. We will be meeting and talking to several of you later this week at NAREIT in San Francisco. We look forward to doing that. Otherwise we look forward to talking to you in early 2007. Enjoy the holidays. Thank you very much.

Thank you. Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you all for your participation.