Spirit Realty Capital Inc (SRC) 2006 Q1 法說會逐字稿

Good day and welcome to the Spirit Finance Corporation First Quarter Earnings Release for 2006 Conference Call.

[OPERATOR INSTRUCTIONS]

It is now my pleasure to turn the floor over to your host, Miss Cathy Long of Spirit Finance Corporation. Please go ahead, ma'am.

Good morning. Thank you for joining us on our first quarter 2006 earnings conference call. I'm Cathy Long, Chief Financial Officer of Spirit Finance Corporation. With me on today's conference call is Mort Fleischer, our Chairman and Chris Volk, our President and Chief Executive Officer.

Before we begin I need to remind everyone that part of our discussion this morning will include forward looking statements. They are not guarantees of future performance and therefore undue reliance should not be placed upon them. We refer all of you to our filings with the Securities and Exchange Commission for a more detailed discussion of the risks that may have a direct bearing on our operating results, performance and financial condition.

And with that, I will pass the call to Mort.

Thank you, Cathy. And thank you everyone for joining us today on our conference call to discuss our first quarter 2006 results. I'm very pleased that this call occurs in concert with our announcement this morning that we have entered into a definitive agreement with ShopKo Stores Inc. to acquire 112 ShopKo properties and 66 Pamida properties including corporate headquarters and distribution centers for approximately 815 million which will be leased on a long term basis to ShopKo Stores Operating Company LLC and Pamida Stores Operating Company LLC, newly formed ShopKo and Pamida Operating Company.

For those not familiar with ShopKo, ShopKo Stores is a retailer of quality goods and services with 135 ShopKo stores and 3 ShopKo Express RX stores, which is a new and convenient neighborhood drug store concept located in 13 Midwest, Mountain and Pacific Northwest states. The stores provide quality name brand merchandise, pharmacy and optical services in midsize to larger cities. And Pamida Inc. is a general merchandise retailer with 216 Pamida stores, of which 116 contain pharmacies which bring value and convenience close to home in small rural communities in 16 Midwest, north central and Rocky Mountain States.

Before I get too far, let me tell you about the structure of today's call. I will provide some introductory comments, then Cathy will review our financial performance for the quarter as well as provide updated guidance for 2006. Chris will then discuss operations and provide some additional detail on the ShopKo transaction. Following our prepared remarks we will be happy to address any questions you may have. We will basically be limited as to the amount of detail we can provide on the ShopKo transaction beyond the comments we will make in our filings with the SEC as the transaction has not yet closed.

With our announcement today coupled with our strong first quarter results, this company has made significant progress in three short years. It is important to understand that Chris Volk and I started this company with a long-term vision to build shareholder value as we assist our customers with more efficient real estate capitalization strategies. We formed Spirit Finance to lower our customer's cost of capital by improving how they finance their operationally essential real estate assets. The ShopKo transactions is a stunning example of this and a win/win for each of the parties involved.

In this transaction our client improves the efficiently of their balance sheet through the sale leaseback 178 properties and does so in a tax efficient manner due to Spirit's ability to add increased material value through financial structuring. As a result, our announcement of the sale leaseback transaction reflects our pending purchase of ShopKo stock as a means to acquire their real estate. Just as important, our shareholders will benefit from the increased FFO we expect this acquisition to generation. With the expected closing of this transaction this quarter we will have acquired almost $1 billion of property in the first 6 months of 2006 exceeding our acquisition and investment goal for the entire year.

In a little over two years as public company we will have acquired more than 2.5 billion in operationally essential real estate assets. We believe that over time this company can build a balance sheet that approaches $20 billion or more. It will take time to get there and it will be lumpy along the way but we believe there exists many large and small opportunities for us to help corporate America in creating capital efficiency and we intend to pursue all of these opportunities. With that let me return the call to Cathy.

Thank you Mort. I'll start by providing a review of the results of our first quarter 2006 activity. Then I'll provide an update on our real estate portfolio and an update on our guidance for 2006. During the first quarter of 2006, which does not include today's announcement of ShopKo, we continued to reap the benefits of the growth in our real estate portfolio over the prior quarters. First quarter FFO per share and AFFO per share improved 40% year over year to $0.21 per diluted share. Net income was 8.1 million, or $0.11 per diluted share on revenues of 34.5 million. Including revenues classified as discontinued operations, which I'll discuss a bit later.

The difference between GAAP earnings and FFO for the first quarter 2006 consisted primarily of depreciation and amortization of $8.2 million. It is important to note that our FFO continues to track closely with our adjusted AFFO with the difference represented only by straight-line rent revenues of less than $0.01 per share. I also point out that our FFO and AFFO are of high quality since they represent recurring cash flows, which are expected to grow through future rent increases and continued Spirit investment activity in newly acquired property. Also because our portfolio is comprised of net lease investments, we have little in the way of capital expenditures that would otherwise detract from reported FFOs.

As we've mentioned on prior calls, must of our portfolio rental increases are contingent on changes in the consumer price index. And are reported as revenue only when the actual CPI increase is known. That means that our current revenue is much closer to actual cash rents received than if we had a sufficient component of our revenue represented by straight-line rents. We expect our CPI rent escalators on our existing portfolio to translate into same store rent increases in the future, averaging about 1.5% annually.

Through our expected continued acquisition activity, total revenue can be expected to rise at a much more significant pace. The weighted average current cash on cash yields in our portfolio is approximately 8.5%. And note than any future CPI rent escalators and any percentage rents, which are based on a percentage of the lessee's gross sales would be additive to this yield. In the first quarter we completed over 151 million in real estate acquisitions. This includes adding five new customers and 41 properties to our portfolio.

Our first quarter investment activity represents approximately a four-fold increase over the 38 million of investments achieved during the first quarter last year. Turning to our balance sheet. At March 31st 2006, we had 1.8 billion in total assets, including almost 1.6 billion in gross real estate owned. 70 million in mortgage equipment and other loans receivable and 156 million in cash and cash equivalents. At the end of the first quarter 2006, we had a billion in debt all of it long term, fixed rate, mortgages and notes payable. We had no amounts outstanding under our variable rate secured credit facilities as of quarter end.

In addition at March 31st, nearly 90% of our investment portfolio was match funded with fixed rate long-term debt, which essentially eliminates our exposure on our current portfolio to rising interest rates. At March 31st, 2006 our investment portfolio was comprised of 719 owned or financed properties, geographically dispersed across 41 states with our top 3 states being Texas at 16%, Arizona at 7% and Florida at 6%. The top 3 industries in which our customers operate were restaurants 30%, specialty retail at 13%, and movie theaters at 12%. As of March 31st our top 10 clients represented 34% of our total investment portfolio down from 53% a year ago.

The weighted average maturity of the non-cancelable portion of our leases is 14 years. Providing us with stable, long term cash flows and less than 3% of our lease portfolio will expire in the next five years. Subsequent to the closing of the ShopKo transaction we expect some changes to our portfolio mix.

From an industry diversification perspective, with ShopKo and Pamida locations included, we will own or finance close to 900 properties. Our properties will be geographically dispersed across 42 states with the largest concentrations in the states of Wisconsin, Texas and Minnesota. Additionally the new ShopKo and Pamida locations will make up our largest industry concentration of general retailer properties. While at the end of the first quarter 2006 we had only one customer representing more than 5% of our portfolio, ShopKo will represent approximately 30% of our balance sheet in the near term. Taking into account the anticipated ShopKo investment, the second largest Spirit customers will be reduced to 3% of total investments.

Turning to property sales, on occasion we acquire properties as part of a real estate portfolio we're certain that the properties do not meet our long-term strategic investment objectives. We sold 6 such properties during the first quarter 2006 that had an aggregate investment value of approximately $5.7 million.

Current accounting principals require that we report the results of our sold properties including the gains or losses on dispositions as discontinued operations. This classification has no impact on reported cash flow, net income, FFO or with the reinvestment of the proceeds, or expectation of future revenues.

As we have anticipated our FFO dividend payout ratio for the first quarter approximately 100%. Since we listed Spirit on the New York Stock Exchange in December 2004, our dividend payout ratio, even with the 10.5% dividend increase in the fourth quarter of 2005, has steadily fallen from almost 130% to its present level as we've grown the company.

We continue to expect that our dividend payout ratio will fall below 90% of funds from operations as we continue to growth our FFO. The recently announced ShopKo transaction will speed up this process, brining up more room for future dividend increases. Turning to credit. We continue to adhere to our diligent underwriting standards and portfolio monitoring process. This strategy has resulted in a strong real estate portfolio. As with prior quarters, all of our properties are occupied and current in their monthly lease and loan payments.

Now I'll move on to some other first quarter highlights. In February we completed a public offering of 13.8 million additional shares, which raised aggregate proceeds of $154 million, net of underwriters discounts and offering expenses. We put these funds to work right away by paying down 110 million of borrowings outstanding under one of the secured credit facilities and investing the balance in new properties.

We previously announced the private placement on March 17th of 301.8 million aggregate principal amount of net lease mortgage loans, series 2006-1. This was the second issuance under the innovative and flexible master funding structure we created in 2005. We used the net proceeds from the sale of this series of notes to pay down outstanding borrowings under our secured credit facilities and to give us funds for future real estate acquisitions.

Now I'll turn to earnings guidance. You will recall that we provide annual, not quarterly earnings guidance. Due to the closing of over 150 million of acquisitions in the first quarter, and the anticipated closing of the ShopKo transaction in the second quarter, we have surpassed our expectation of closing at least 800 million of acquisitions for 2006. Right now our pipeline is robust and we believe that we will close our 2006 with at least 1.6 billion in new investments. This is double our initial acquisition guidance.

We should add that larger transactions such as ShopKo, will happen over the course of a given year and it possible that 2006, or future years, may have more than 1 investment of this magnitude. It is just too hard to predict. It is likely that timing of the remaining acquisitions will fall late in the quarter during third and fourth quarters. And to keep our solid underwriting and investment [technical difficulty] and complete those transactions that will contribute to the increased cash flow of this company over time.

Now to update our guidance, given the volume we've completed through first quarter and assuming the successful and timely closing of the ShopKo transaction including obtaining current financing, and assuming additional real estate transactions being completed during 2006, the timing of which will determine how much of the acquisitions will contribute to 2006 FFO, I'm please to announce that we are raising our FFO estimates for 2006 to arrange of $0.99 to $1.04 per diluted share.

Now, I will turn the call over to Chris.

Thank you, Cathy. [technical difficulty]

Mr. Volk, we are unable to hear you.

I'm sorry, can you hear me?

Yes, we can hear you.

Okay, I'll start again. Thank you, Cathy. Upon the expected closing of the ShopKo stores acquisition, we're pleased to announce that we will have closed over $2.5 billion in sale leaseback transactions and mortgage loans since we began investing in operationally essential real estates assets in December of 2003. With the forthcoming single largest acquisition in the short history of this company, pending remaining due diligence in closing we will have met each of the criteria we've set out to accomplish when we started Spirit.

Our mission in Spirit Finance is well underway and the momentum is truly building. By applying our market knowledge and core competencies, we are helping leverage real estate assets better and more efficiently than our customers with the pre tax cost of equity that is about half theirs. This is where our mutual value creation lies. With our objective to apply this value equation across our retail, service and distribution customers who transcend the credit spectrum. Combine this with an ability to tailor structure us to maximize net after tax customers proceeds as in the case of ShopKo and our ability to add value to our customers is, we believe, without peer.

While the definitive agreement is signed, the ShopKo transaction is not yet closed but I can share the following details of the transaction on this call. Spirit Finance will acquire the real estate assets through the purchase of 100% of the stock of ShopKo Stores Inc, and enter into long term triple net lease agreements with affiliates of SKO Group's Holding Corp, who will continue to operate the retail properties.

The following are some of the basic lease terms. The initial base lease rate will approximately 9.1%. The leases will call for escalations every three years based upon future changes in the consumer price index for the maximum increase of 6% every three years. The lease term will be for 20 years for the ShopKo properties and 15 years for the Pamida properties. There will be one lease each for ShopKo and Pamida, which will be structured as master, or unitary leases that encompass all of the underlying properties. The leases will be triple net. The leases have been structured; mindful of the corporate flexibility Pamida and ShopKo need to efficiently operate their businesses.

Turning to our financing of this investment and out financial flexibility, I include the following. The term financing for the ShopKo and Pamida real estate is being provided jointly by Citigroup Global Markets Realty Corp and Barclays Capital Real Estate Inc. we have locked into fixed borrowing costs of 6.6% on this term debt, which provides a 75% advance rate against our investment and amortizes over 30 years with the maturity in 10 years.

Our investment is also enabled by available credit lines and cash. Following the investment we effectively have an internal capacity to fund another $300 million in investment through our credit facilities. Currently we have $500 million aggregate borrowing capacity under our secured credit facilities with an estimated $150 million outstanding after the ShopKo transaction.

Spirit's corporate leverage will approximately 69% of the costs of our total assets immediately following the ShopKo transaction. Combined with our credit lines, we could effectively lever ourselves up to about 73%. Keep in mind that we have not elected to issue any preferred shares today so this leverage percentage should represent our total interest bearing obligations. We have stated that we plan to target an aggregate stabilized corporate leverage in the range of 60 to 65% to anticipate accessing the equity markets again sometime in the future.

Here it is also important to keep in mind that we have always discussed our target leverage as a percentage of total assets and have not used another common convention regarding total market capitalization. We will file ShopKo's financial statements subsequent to the closing of the transaction and each quarter thereafter so long as ShopKo represents 20% or more of our total assets.

Presuming $1.6 billion of investments during this year we expect ShopKo to fall to nearly 25% of total investments by the end of 2006. This transaction increases our presence in the retail sector and we are clearly comfortable that over time we will be able to diversify the balance sheet further, reducing that exposure. We are confident in the existing and future business models of ShopKo and Pamida, together with their leadership teams. Our confidence is further bolstered by the ownership of these two companies by an affiliate of Sun Capital. A Financial investment firm having a solid reputation for investment stewardship.

Both ShopKo and Pamida are leaders in many of their markets where a strong market share and presence in those markets, the assets in which we are investing are characterized by stable individual cash flows, substantial store level cash flow diversity and rents that are consistent on a quarter footage basis within their markets for similar assets. To date we have substantially completed our due diligence on the assets and the stock purchase agreement including valuations, title work, environmental studies, property condition reports and extensive corporate due diligence.

We worked closely with Sun Capital to combine efforts to produce an efficient sale leaseback execution that utilizes technology designed to maximize the after tax proceeds to ShopKo. As you know, Sun is one of the nations' preeminent private investment firms and specializes in leveraged buyouts and debt and equity investments in market leading companies. We look forward to working with Sun and providing real estate sale leaseback capital on future transactions.

Our pending ShopKo investment together with other meaningful potential investments in our investment pipeline was enabled by Spirit's team of financial and investment professionals an also by our highly flexible corporate structure. We were virtually match funded at March 31st and have significantly maintained significant short-term credit ability. Our long term and short term belongs permit us to be highly flexible. Our milestone innovation of Spirit Master funding in 2005 both provides us and our customers an attractive cost to capital together with significant assets and corporate flexibility.

As a new generation REIT such innovations are essential to meet the needs of a marketplace that demands greater efficiency. In summary, I believe that this transaction is important for the following five reasons.

First, the ShopKo transaction together with other potential large investment opportunities will contribute to greater potential - greater growth potential for Spirit Finance. We already stand today as one of the REITs having the highest rates of earnings and FFO per share growth. With this investment we meaningfully raise our 2006 FFO guidance to range from $0.99 to $1.04 per diluted share. On an annual basis going forward, this transaction will represent an estimated $0.20 to $0.30 per share.

Two, the transactions like this one result from our ability to help customers unlock significant value in their corporate capital structure. This goes beyond the traditional notion of REIT real estate ownership. We are providing a treasury tool that lowers our customer's cost of capital.

Third, there is a clearer trend that we see towards corporate capital efficiency, putting Spirit with the capitals in seed technology we can deliver and a sweet spot. We have seen companies moving from driving efficiencies in their operations, to unlocking asset efficiently, to where we are today. Targeting the value sitting on the balance sheet or capital efficiency. We foresaw this trend three years ago when we started Spirit.

Fourth, at the end of the day this is a win/win transaction to both our shareholders and to Sun Capital with both achieving attractive and accretive returns on our respective investments. At the same time our investment is characterized by good and stable cash flow coverage's on the ShopKo and Pamida assets, rational investment amounts, market based rents together with customers having strong visions and management teams owned by an investor with an impressive track record of success.

And lastly, this is the first of what we believe to be many large transactions for Spirit. Our vision is that we could have a $20 billion plus balance sheet over time and if that vision is based in no small part of what we believe will be many significant opportunities for future large-scale corporate real estate recapitalizations. We believe the capital efficiency is the next large frontier for shareholder value creation in corporate America and the Spirit Finance is assuming a leadership position.

Before winding up my portion of this discussion let me turn for a moment to the business development opportunities we do see. At the beginning of May, our pipeline of potential investments continue to be healthy and stood at over $3.4 billion. That includes the pending ShopKo investment and another seven potential transactions that each exceed $100 million. Of our pipeline almost 85% was directly originated with another 10% or so from financial institution referrals. This reflects the trend away from brokered investments, which formally represented a greater portion of our pipeline of potential investments.

In total the potential investments represents almost 500 individual assets with an expected median year one cash on cash yield in the neighborhood of 8.6%. Strategically we're witnessing some potential lease spread compression given the recent 25 basis point increase in the 10-year treasury rate since March, while our price line lease rates have increased by an average of about 10 basis points. That said, many smaller net lease opportunities [that] seen stable lease rates, resulting in greater spread compressions. As a result our pipeline has gravitated to investment opportunities for financial flexibility and the tailored structuring that we can provide, offer better value for our customers and our shareholders.

We have always sought to be disciplined investors and pricing is an important part of that equation. So what we're seeing today is a larger pipeline, but one that is now weighted by larger potential investments. The opportunities we are seeing are exciting, ranging from public company balance sheet restructuring, to work with private investment firms such as Sun Capital. With all of the opportunity we see, we're optimistic regarding our expected investment activity relative to our accomplishments in 2005. On the other hand, there's likely to be greater investment volatility from quarter to quarter.

We're dedicated to seizing an opportunity to efficiently use Spirit as a valued means of helping our customers use sale leaseback technology as a treasury tool to lower their cost of capital. Let me close with a few comments on why Spirit. We have a clear vision and upon us innovative technology to place Spirit in a strong competitive position to help retail service and distribution companies create value for their shareholders by using our capital to lower their cost of capital.

The market for what we do is extremely large and our view is growing but we expect to have met our annual acquisition goal in the first half of 2006. We will continue to pursue acquisitions that fit our return expectations. We believe that the next great wave of real estate to enter the REIT marketplace will come from the balance sheets of corporate America and we have positioned Spirit as a uniquely qualified player to assume a leadership position having size and scale. Our already rapid FFO per share growth as we demonstrate it today can potentially accelerate as we secure larger investment transactions.

We believe we have a terrific platform. We have broken new ground within real estate investment trusts with our liability strategy. We have a sales organization with momentum; we have harnessed the latest technology run Spirit efficiently and with a highly scalable business model.

The long-term objective is to turn this unique REIT platform to address the increasing needs for corporate America for capital efficiency on a larger scale. The quality of our funds from operations is strong and recurring. For 2006 we expect that our dividend payout rate will fall below 90% of funds from operations as we continue to grow our FFO per share. And lastly and always, management is strongly aligned with our shareholders and we will continue to pursue the use of efficient capital to create meaningful opportunities for the company.

With that said, Operator I'd like to open the line for questions.

Thank you. [OPERATOR INSTRUCTIONS] Our first question comes from Ross Nussbaum with Banc of America Securities.

Hi, good morning everyone. Chris, could you provide us with what the rent to EBITDA coverage is on each of the master leases?

What the rent to EBITDA coverage. If you look at the - obviously ShopKo was a public company up through December 28th of last year, so you have available to you a Q that you can look at, but the corporate coverage will be north of 150 and the store level coverage will be higher than that.

It's important to point out that when we file - we will file an 8-K upon closing of the transaction and shortly after that we'll file most likely another 8-K that will include the year end audit for ShopKo. And that year end audit will be done so that it's comparable with ShopKo as a public company. So even though Sun only held the company from December 28th to January 31st, which is January 31st their fiscal year end. You'll see the 12-month numbers from January to January so you can make -- draw direct comparisons to it; what they were as a public company.

Great. And you had talked about the leases being structured to give ShopKo some operating flexibility. Can you elaborate on what you mean by that?

Well typically our leases contain abilities for companies to substitute stores, assign stores, sublease stores, and as you might guess, this is being - with this being executed in the commercial mortgage backed securities market, its important to kind of set that flexibility tone up front and to negotiation with the banks and financial providers what can be done. So we work very hard together with Sun to enable them to have as much flexibility as possible to run their business.

But these I assume the guests are all cross-consulted within the master lease?

Well, they're master leases, so they're effectively unitary leases so you can't cross collaterize a lease of course because you own it but you effectively are cross defaulted in a very pure sense because there is only one lease for each entity.

What were the deal costs above and beyond the 815 million?

Well they haven't been set yet Ross, I mean so we don't have all the numbers and Cathy, I don't know if you want to comment on that at all.

Until the transaction closes, we won't have all the costs.

Okay, and then just one final question, which is - I want to make sure I got these numbers right Chris, you could answer them real quickly. You're going to put 75% mortgage debt on this and the rest temporarily gets funded on the line?

That's correct. And cash, we have cash. You saw at the end of March we had $150 million in cash on our sheet. So obviously we're going to be acquiring other properties besides ShopKo transaction this quarter. And between the cash and line borrowings we'll fund the ShopKo transaction.

Our next question comes from Susan Jansen with Lehman Brothers.

Good morning. Couple of questions. One to confirm. I think you said that ShopKo's rents were largely at market value in the local communities and the second questions is, I wanted to understand how to think about the value you are paying, is there a cap rate or can you give some color around that?

Well, the lease rate is 9.1%. So - approximately. So that - and the lease rate is determined based upon the purchase price, so we're not buying existing leases where we're buying into a cap rate. We created the cap rate. And the cap rate is a function of our return expectations and our cost of funding.

As far as the leases and - the lease rates for the stores and also for the market. These stores have been appraised by multiple appraisers and they've been looked at by a lot of professions and the idea, of course as with anything that Spirit has done, is to make sure that we're investing appropriately and we're investing at rates that can be justified while within the marketplace.

That's very helpful. Thank you so much.

Thank you.

Our next question comes from Jessica Sully with Credit Suisse.

Good morning. I wanted to ask, is there any flexibility and would you benefit from this or would the ShopKo management team benefit from this? If down the road there was sort of a situation kind of like what's being done with Albertson's, you know how Albertson's being split apart and some - one company's buying some of the real estate, another REIT group is buying basically the real estate and trying to sublease it and things like that. I wondered if there is anyway you could benefit from that and conversely are there ways you could be protected from maybe having [inaudible] subleases that are not high quality tenants.

Well, sure Jessica. This is Chris. First of all, with the Albertson's transaction and Albertson's had about $8 billion worth of gross book real estate on their sheet, and it was determined and I believe I'm correct in saying this, that the company decided that they would have certain markets that they wanted to retain and other markets they didn't want to retain. So super value is continually operating the store, the markets they wanted to retain and the [Serbose] and Kimco are divesting them from markets that they didn't want to retain.

The decisions to do that, as with the decisions to do let's say the Toys R Us division which has been done or the Kmart division which as been done, results in the fact that many markets or Mervyns for that matter results in the fact that a number of markets were viewed as being uneconomic. That is - that's not really where Spirit plays. Spirit is spread investor and Sun is determined and the management teams of ShopKo and Pamida's determined that the markets that we're in are economic and the markets that are being invested are long term markets - long term stores that they'd like to keep.

That being said, we have some flexibility from substitution perspective, down the road things always change in this business and its important to give our clients as much flexibility as we can, but the opportunity we're really delivering is one of efficient long term capital to hold the core assets that companies desire to retain to run their businesses.

So what if they decided down the road that certain markets were uneconomic, how would that affect you?

With any of our customers decide that certain economic roads, certain markets down the road are uneconomic, we're going to work very hard with any customer that we have to make sure that they can run their business properly and make the right decisions for themselves.

And then, just on a different subject. I think in the last call you had mentioned that because of the yield curve being more or less flat that you might do some transactions, in other words try to capture some quicker transactions in terms of purchasing a net lease asset and then selling it into the 1031 market or something. Are you still planning to do that?

It's conceivable that we may do a little bit of that this year. We never said it was meaningful, so it really won't matter virtually anything to FFO per share whether we do it or not.

Great, and then Cathy, could you repeat how much total acquisitions you expected for this year? I think I missed that number, including ShopKo, of course.

Yes, Jessica, we think we'll be at 1.6 billion for the year, including ShopKo.

And how much have you done so far?

We've done the 151 million plus -

ShopKo.

ShopKo's not yet closed, but we anticipate for second quarter.

Thanks, very much.

[OPERATOR INSTRUCTIONS] Moving along to [Michael Bylantry] with Citigroup.

Chris, maybe you can go over for us, I guess a 75% debt, you said it was at a 6/6 rate and with the other acquisitions you're going to do for the year, I guess the equity needs is about $400 million. How do you intend to - is that going to be all common doing a jumbo $400 million equity raise?

No Michael. I mean our view is to - when we raise equity in the future to do it in a much more bite sized chunks. We're not interested in creating a big dilution or overhang. Some dilution overhang was created when we started Spirit of course in 2003 in the beginning and in the end of 2004. That's not our expectation going forward and of course in early this year, when we raised about $150 million, that was also a more bite sized chunk that could be readily deployable, which as you can see today it is.

You're already sort of at that 60% leverage level and I assume buying this 815 with 75% leverage and doing another $400 or $500 million of acquisitions, you're going to have some common equity need this year or your leverage is going to go way above 70%.

Naturally, and we made that statement in our remarks on this call. We're going to need to raise equity capital. I think what we've done Michael is, we've been able to structure Spirit with enough credit lines that rather than having to sit on cash and under lever the balance sheet, we can actually lever the balance sheet a little bit and then pay down the leverage which I think, from your perspective is - and analysts, or from the perspective of our investors is a better transactions because it means that their money has been put to work right away.

And so, that's really been our effort in terms of creating a company that's got corporate flexibility. As I've said, in the call, we effectively have, if we choose to use it, another $300 million or so worth of availability to make investments without having to go to the capital markets. So we have a lot of flexibility in that standpoint.

Well maybe the way to think about it. If you buy the 1.6 billion total for the year, how much equity capital will you need to take you back down to that 65% leverage level?

The number could be $400 million that would be correct.

And then if the equity market is not open, how do you think about. I think you talked a little bit on the last call about maybe doing in some of these elephant transactions, bringing in partners. Is that another option for you and have you had those discussions.

The answer is that there are a lot of people who know who we are, and we've had extensive discussions and so there are clearly a lot of avenues of capital and Mort and I have been doing this for over 20 years and have a lot of experience in accessing different capital markets depending on supply and demand issues in any one market and we're conscious of that.

When you gave out your $0.20 to $0.30 of accretion I assume you're just using the 9/1 yield and a 6/6 cost of debt at 75%. I guess to get to the midpoint of that range or cost of equity would be 6%. Am I missing something?

My cost equity is what now pleases?

Well no I - you said the deal was $0.20 to $0.30 accretive and I was just plugging in the numbers using a 9/1 initial yield of 6/6 cost of debt and solving for $0.25. And you get to a cost equity of six, seems a bit low.

I would say to you, and I don't know how you do a lease pricing model, but I could show you the pricing model and its well north of 12% total rate return.

And so this is, to come up with that is sort of you're looking at a long term, not the initial, its not - the deals not $0.20 to $0.30 initially accretive, you're thinking about it over a longer time period?

No next year, in a full calendar year - if you were to do this - if you were just to sit there and look at the spread, because Cathy and I are mindful that all of you are going to be doing this, so if you were going to sit there and look at the spread, you're going to come up with about $0.33. But what you've got to do is, you've got to factor in first of all, there are some marginal costs to running this thing.

So there are servicing costs. In addition to which, the transactions at 75% leverage which is a little bit more than we tend to keep our sheet overall, so if you assume that we, you'll lever some assets a little bit less in order to keep the leverage kind of in the 65% range, its going to end up being sort of in the neighborhood of $0.20 to 0.30.

And that's on a, that's including an equity cost in that calculation, issuing shares.

Yes, sir.

Okay, how much square footage did you acquire?

The ShopKo stores are roughly 10 million square feet. The Pamida stores are roughly 2.2 million square feet. There are three distribution centers for ShopKo which average about 458,000 square feet a piece, there is an optical lab for ShopKo which is about 30,000 square feet and there are two offices, 1 for ShopKo and one for Pamida which both are around 215,000 square feet.

And how did you - just walk us through the credit process of getting comfortable with ShopKo as a tenant just given its past sort of issues. And then also thinking that if ShopKo wasn't able to succeed in the future, how you got comfortable with the releasing risk, given the size of the ShopKo box and then the Pamida sort of rural town concept in terms of what your backstop is in all of this?

Okay fine. Well first of all I'll start with Pamida. Pamida as you pointed out is a rural town. So basically their populations of less than 10,000 people typically in local marketplaces. Mort and I basically got started going that. I mean the very first Hardees Restaurant we ever did was in Grafton, North Dakota, you had to put a blanket on top of the engine to start it. So our view is that these stores are - have very nice market positions as neighborhood center town discount retailers.

The Pamida locations have - when the company was public about 22% of their locations had pharmacies and - or 22%, excuse me 22% of their revenues came from pharmacies, which was about in half their stores. The ShopKo stores by the way had pharmaceutical sales around 30% of sales and that was in virtually all their stores. The ShopKo stores do something like 12.5 million prescription a year and 700,000 eyewear prescriptions, give or take. So for both cases one of the things that we liked about this was just the notion that you had good retail operators that were diversified with strong dedication to the health care business, which we view as being more stable.

Second thing is if you look at the company and pull out the 10Ks or Qs of ShopKo as a public company, you'll notice that in 2004, ShopKo had operating earnings and I'm talking about operating profit as EBITDAR, so before rents, sort of in the neighborhood of 205 million, in 2005 it was 209 million and 2006 the - it was only through Q3, which their Q3 ended in October so the company was sold to Sun in December. So you'll see with our filing what '06 looks like, but Q3 was on track to be consistent with the results from '04 and '05.

So basically you're talking about a company that had been very stable from a cash flow perspective. We believe and I believe the existing management of the company believes that there is a lot of upside to be had in addition to that, but Mort and I have always looked for company's having good market shares, meeting customer demand, and having stable cash flows and I think that if you just look at the results of the company you'll see that.

In terms of the equity funding, you talked a little bit about preferred. Do you think about doing that and is that - you count that as leverage in thinking about the 65% target?

I think that when you do preferred stock Michael that you should build that into your total leverage number, because for REITs preferred stock, especially trust preferred stock is a debt substitute and I would argue almost a preferred stock in general is a debt substitute and the - in a REIT of course you don't have the issue of the tax deductibility or lack thereof of preferred dividends that you would have in a corporation, so from a tax perspective, whether its preferred dividend or interest its all the same.

And from our perspective, we've gotten much more efficient execution on the debt side at this point in time. If we think that it makes sense to go to the preferred markets you know that Mort and I will consider that.

And then [I have] two questions left. You said there was a number of transactions greater than 100 million. How big is the largest transaction that you're looking at?

I can't answer that right now. It's not this big. I'll tell you that.

And then are - how about going outside the US and starting to think globally?

We - obviously we have - Mort and I cannot be accused of not having imagination, but the answer is we're focusing very heavily on the United States right now.

Great. Thank you very much for your time.

Thank you.

Our next question comes from Ken Avalos with Raymond James.

Chris, can you talk a little bit more about sort of what you and the ShopKo management team sees in terms of upside, any sort of commentary on recent sales trends, store openings and do they plan to grow this business?

Well, the answer is if you look at the ShopKo stores, the average age is probably 1985, I mean obviously they've been well maintained and whatnot but that's the average age. The newest ShopKo was built in 1996. Pamida stores, I think the average age is around 1990 and the newest store was around 2000. And so, the company itself as a public company was essentially for sale for almost two years. Went through an extremely long and arduous sale process during which time there was no expansion plans, which I should say that there's a lot of credit is deserved to management to maintain the kind of consistency of operations and corporate cash flows that you have if you're operating under that kind of environment.

Today they're looking obviously at expanding. I think that's something that their [aptly] considering and there are a number of things that are being considered relative to operational efficiencies that I cant go into right now, but I think that suffice it to say that Sun has a reputation as a shareholder for looking at ways to efficiently run companies and they have a lot of ideas.

Thanks.

Our next question comes from Chris Lucas with Robert Baird.

Good morning everyone.

Hey Chris.

Just a couple of follow up questions, just on Ken's question there. Will you guys have rights to additional new store openings if ShopKo does expand their stores?

The answer is that we - if we were an investment bank we probably would have tied them up with rights because investment banks like to do that you know. But we didn't do that.

Okay.

The answer is no.

And then on - just on the guidance Cathy, I think last quarter you had indicated that there would be some incremental benefits through gains from sales of $0.03 to $0.05 for '06 in your prior guidance. Does that still hold true for the current guidance.

It's potential. That's correct. I mean three - I would target the lower range of that number, maybe less. And - but there is some potential for gains and sales. I should point out to you too, it's a small thing, but somewhere around 37 of the ShopKo Pamida properties that we're acquiring have out parcels with them and it's conceivable that some of those our parcels get sold off and that we would work with the ShopKo Pamida teams to effect that.

And then in terms of the acquisitions that were completed in the first quarter, Chris could you give us a little flavor for what they consisted of and what the cap rate was on those transactions.

What I will do is I'll first - I'll start off, I'm going to turn this over to Cathy and we have Jeffrey Fleischer in the office. Mort and I are on the road from a different location today, but the biggest transaction that we did of course was the Men's Warehouses transaction which was publicly announced and that was funded through the CMBS marketplace and the Men's Warehouse is the leading retailer and distributor for extra large clothing for men. And but outside of that Jeff and Cathy. What can we say about the overall mix?

We had restaurant properties that were purchased primarily four or five clients that were restaurant related. You're looking at cap rates they were in the 8s. Considering Casual Male was a higher credit than some of the other ones. So when you take the blended rate, it was over 8 -- 851.

Okay, great. Thank you. And then just a more general question Chris, on credit spreads between - to below investment grade, what are you seeing in the trend there recently?

Credit spreads, well having our own conduit is a huge advantage for us because Spirit Master Funding can essentially access BBB to AAA cuts of money irrespective of what the credit is that goes in there, so we're able to lock that in. I would say the last master funding transaction that we closed, Cathy was closed at 5.9%, is that right.

The last master funding transaction?

In February.

Was 5.76.

5.76. Now that doesn't include Chris the cost of monoline insurance which we had, nor does it include the costs of hedges, although the hedges were a gain for that transaction. So we were probably all in, sort of around 6%, which is kind of where we were at last year from a cost of money perspective. With the quarter point increase, we're probably talking about 6.25 to 6.35 something like that. So you're talking about a slightly higher cost of money going in. so it becomes important for us to make sure that we invest in accretive transactions and do our best to keep the cap rates higher so we can move the cap rates out by an equivalent amount so we can keep our return on equity where it needs to be.

Okay and then my last questions going to be on, just on the larger deals you're seeing, what - any flavor as to the types of businesses or where the leads are coming from, how you're generating those larger transactions?

I can't talk to you about types - I mean the types of business are all just retail service and distribution companies. In many cases they're institutionally held and large privates and in some cases they're existing publics. Obviously in today's world of activist shareholders we're looking to get companies to have their balance sheets be made more efficient. I think that some of the value that Spirit can add is definitely being realized, people are understanding what we can bring to the table so we're excited about that.

As far as leads, I would say that a lot of the stuff that we're doing is direct, but we're also getting a lot of assistance from the financial institutions that represent us. And you saw that on this transaction the financial institutions that were engaged by us and Sun included Barclays and Citi and Goldman, and of course there are other banks that we work with as well that we're working closely with on transactions.

Okay great. Thank you, very much.

The next question comes from [James Pacelund] with Credit Suisse.

Hi, good morning everyone. Just in - I guess follow up to this last question, do you see an increasing percentage of your annual deal flow coming from private equity capital firms such as Sun Capital? And also, you did just speak about marketing, but is your marketing team actively focusing on private equity capital firms type of deal sources?

This is Mort, the answer is perhaps. We may see it more come from private equity as they begin to understand clearer that the use of a sale leaseback is a very good tool to help them drive return on equity and as we see more activists shareholder activity, they'll also become more aware of what we're able to do with this type of treasury tool, or using a sell leaseback as a treasury tool.

We're opportunists. Wherever we - when we see that the markets move we move in that direction, so its clear to us that private equity is a very good source of this type of transaction and we - I'll assure you we intend to call on them.

Okay, thank you Mort.

And we have a follow up question from Michael Bylantry with Citigroup.

Hi, Chris does this represent all of the owned real estate of ShopKo?

It represents substantially all the real estate. There are a handful of properties that are not included.

And then are you intending to sell any of the assets, some maybe that you weren't comfortable with or is there any rights that you have with that?

No we're not intending to sell any and the ones - any ones that we left outside of the pool were ones that could be a possibility, but we don't own those.

And what's the range of cap rates or yields that you had on the assets? I assume some of these probably have a little bit higher given the cash flow generation.

Its just one lease with one lease rate Michael. So there's -- I mean clearly from sort of - as with all retailers there are some stores that you have more four wall cash flow than others, but the cap rate is not driven off of that, its driven off of the investment.

Okay, thank you.

As I was sitting there, I haven't penciled this out, but I mean if we're at 90% and we're getting 75% leverage and we're locking into a 2.5% spread, I mean you can sort of do the math and get to a return on equity just on an initial cash basis that's north of 12. I mean -

What does ShopKo look like on a balance sheet perspective after doing this deal?

Well, I mean ShopKo, you can look and see - I can't tell you specifically because their financial statements will get filed, but you'll see I think things that would be rational to expect. Will be that given the purchase price for ShopKo they'll have virtually no debt on their sheet or very low levels of debt on their sheet because we're providing such a large portion of the source of the cash for the company, for the company purchase.

How much capital equity is Sun going to have in the deal in the end once it's recapped through your sale leaseback?

I can't tell you that right today, but you'll see it in the financial statements when they get filed.

Okay, thank you.

Okay sure.

Let me summarize and just briefly point our attention to why did we start Spirit. Chris and I saw that there was too much of everything, and the Sun transaction is a good example of how we believe things are going to get more efficient. Globalization is driving margin compression. Its making these retailers, it's much more difficult to open new stores, you can only close so many stores. You can close yourself right out of business. The phenomenon that surprised I think all of us in America, which Mr. Greenspan clearly observed some years ago, is increased productivity and that seems to be continuing.

So if we think - Chris and I think this supports our vision and our theory that balance sheet efficiency is the next frontier for corporate America, the ShopKo transaction supports this thought. Let me give you some very simple entrepreneurial math, which is what I like to do and why we think a REIT is the right vehicle to do this.

If you're running an operating company -- and focusing on return on equity is what we think more and more people are doing, as you see the activist shareholders continue to make a lot of noise about this. So if you're running an operating company, you should be thinking in terms of 20 to 30% return on equity or more. We, at Spirit, if we can make a 12% levered rate of return after the cost of running a business, we think that you as investors would be thrilled with that and Chris and I would be thrilled with that. So, it's a natural marriage, why do you want to hold these passive assets in an operating company? It defies logic.

So logic in our system is hard to defy. We all know [Adam Smith] is still out there and we believe that this offers Spirit a huge opportunity and we intend to exploit that. Thank you very much for being on the call today.

That concludes today's teleconference. We thank you for your participation. Have a nice day.