Phillips Edison & Company, Inc. (PECO) Earnings Call Transcript

Good afternoon. Thanks for joining. For those who don't know, I'm Craig Schmidt, and I cover the retail REITs at Bank of America over here and the blonde is [ Emily Arso ]. She is on team retail. We're pleased to introduce the PECO team. Devin Murphy is on my immediate left. He is the President. His left is Jeff Edison, Chairman, and CEO. And then at the end, we have John Caulfield, CFO. I'm going to hand it over to Jeff and team and have them start with some opening remarks, brief overview of PECO, and get into questions. Plus, I want to keep it as interactive as possible. So don't hesitate to raise your hand and ask questions or just start out with the question. So let me turn over to your team.

Well, thanks, and thanks everybody, for coming today. We appreciate you being here. And as we said, let's make sure we keep it interactive and questions. We love the questions. And just to get started, we're… As we all know we're in a pretty interesting environment. We became public about a little over a year ago. Our thesis at the time was that we had a very differentiated strategy from other people in the retail business and focusing on 5 shopping centers to have the number 1 or 2 grocery and are about 115,000 square feet. They sit at the corner of [ main and main ] and they deliver goods the last mile to people's houses. And 75%, 80% of that is necessity-based, and 30% to 40% of the income is coming from the grocer. And that's a very different format than a lot of different retail, whether that's power centers or lifestyle centers or malls and it operates differently. And that was our thesis, and we've continued to take that thesis and to prove out that it is a very resilient strategy. And if you look at what happened during the virus, we lost 0.7% of occupancy. Today, we have 92% retention rates among the highest we've had in the history of the company. And we're seeing very strong same-center NOI growth. We're seeing our leases move at numbers that both new leases and our renewal spreads at numbers that are very strong historically. So in an environment where the operating side of the business is going about as well as it can. And yet, there's a storm out there in the horizon and everyone wants to know what's happening with the storm, which obviously, we've been doing this for a long time. We've been in the business for 30 years. So we've seen a lot of cycles. This one is interesting and it's unique. We have a very strong employment base, which drives a lot of our customers and a lot of their shopping for necessity goods is driven by strong employment rates. And that works really well in our environment. And yet, we've got inflation, we've got a [ bed ] that's going to slam on the brakes. So we're going to deal with that. We've seen that, and that's the second thing that's going on there with obviously increasing interest rates, which are going to have a negative impact on cost capital and valuations. It hasn't happened yet. We continue to wait for the -- when I say the impact of that on the acquisition pace. That hasn't happened yet, but it is in the process, and we're starting to see that the acquisition of that change in the cost of capital. So we're working through those 3 issues of increasing debt costs, the acquisition market that's in transition and a really strong operating environment. I think the transition on the acquisition pricing, the private market pricing is going to take longer. And I say that because I think you're going to have to have some operating disruption before you're going to see pricing change the way that it has on the debt side of the -- of your cost of capital. So that is our view of sort of how the world is going and the uncertainties that are out there. What we -- the fact that we are a necessity based in terms of our retail base is we think critical. It gives us the opportunity to weather these storms as well as take advantage of these storms in a way that's really positive. We also have one of the best balance sheets in the business, and that gives us a lot of flexibility. So we think that there's going to be opportunity that comes out of what we're going into. We think it's going to take a little longer than the way it's done happened historically. And -- but that doesn't make the opportunity less. And we think with the balance sheet that we have right now, we're in a really good position to take advantage of that.

Great. Well, let me kick it off now. We go to the second quarter end of June that leasing has been done very wealthy. And like you say, you've already returned to pre-COVID occupancy, your leasing spreads have been double digits for at least the last 3 quarters -- has that continued through, let's say, either end of August or mid-September?

Yes. We find that in the leasing market today, Craig, is, again, demand is being driven by a number of macro factors, work from home, organization, the migration to the Sunbelt, and all portfolio benefits from all of those macro trends. And those macro trends are continuing in a wheel and there's some interesting place or AI data that's recently come out that confirms those trends and shows the incremental population that is now surrounding our centers versus where it was 4 years ago. So those macro trends are driving really strong demand from the retailers. And then as you know, there's been virtually more supply added over the last 10 years. And our expectation is there will be very little supply added because when you look at placement costs today versus where we're acquiring centers in the market today, that discount to replacement cost is depending on location, 40% to 50%. So we believe that the demand cohort is going to continue and the supply cohort is not going to change. And that's going to continue to allow landlords to have really great pricing power. And as Jeff indicated, we're 97% leased today. We have 92% retention. Our re-leasing spreads in the second quarter or when the mid-teens relative to 8% to 10% historically. And our new leasing spreads were in the mid-30s, which is meaningfully higher than they've been historically. So the operating environment, as Jeff said in his opening statement is as good as we've ever seen it. And the headwinds for us are these capital markets headwinds in terms of cost of capital.

Okay. And then are you hearing any comments from your retailers that this may slow given the potential recession in '23 And/or are they saying that -- I guess the way to look at it is how active have you been in '23 and '24 leasing?

Yes. So if you look at assuming our historical retention rate or rent for 2023 is 98% in place. And for 2024, it's 95% in place. Now, that assumes we're able to retain tenants at the level we've been able to do so historically. But we're not seeing anything that leads us to believe that, that will change. I was just speaking to our Head of Leasing yesterday, and he said that in recent dialogue with retailers, they're actually more constructive today than they were in Q1 in terms of their perspective on growth. And his thesis for what it's worth is that for the consumer that is shopping at our centers, gasoline prices are a meaningful metric. And in the first quarter, when gas was going from $3.50 to 5 that had a shop factor that was reverberating through and that's obviously been mitigated. And what we're hearing from the retailers is if they can find labor, which is their biggest challenge, they will continue to open stores at the current pace that they're expecting.

Okay. I mean there's actually 2 audiences you have. Obviously, you have the 10 -- the retail tenants themselves, but then you have the consumers. Are you seeing any slowing or pullback from the consumers?

Great question and one that what we're hearing from the grocers is that you're starting to see a trade down to private label from the branded goods. And that's typically an early reaction of the consumer heading into a recessionary period where there's a question -- just -- it's a first step they take. They also tend to stop going to restaurants, like the restaurants and moving down brand are the 2 first steps. And there's we're seeing that more on the growth side than we are on the restaurant side, but we anticipate seeing that on the restaurant side as well. So that’s the earliest signs that the consumer is reacting to this. But it's not changing the number of business they're making, and it isn't changing the market basket dramatically according to Kroger and to public in our conversations.

And their businesses continue to be very strong, Craig. If you looked at their second quarter results, they all had same-store sales growth in the high single digits, and they had margins that were constant or improving. And so despite the dynamic that Jeff talked about with the consumer trading down to private label, the label has a higher margin to the grocer. And so that's a positive benefit for at least in the short term as long as they can hold on to that consumer and make sure he doesn't now trade down from a Kroger to a lower-end grocer.

Okay. And I guess where would you say -- I mean you had record high occupancy, how much further can you push that occupancy? And is your growth profile reduced to some of your peers?

Yes. So we think we can take our in-line occupancy up by another 200 to 300 basis points. We think our anchor occupancy is pretty much at -- we have 10 anchor boxes currently that are vacant. So we think we're at frictional vacancy with the anchors. We still think we have occupancy upside in our in-line. And we realize that we are at the second highest level of occupancy of any of our public peers. And therefore, the way we need to drive growth is by continuing to push rents, which we will do. And if you look at our spreads, they've been pretty attractive. And in addition to those spreads, we're also getting 2.5% CAGRs built-in on top of the spreads that we're getting. And then obviously, an important component of our growth is our external growth, which Jeff will get into at some point, I guess soon.

Okay. I guess what I wanted to -- I think in your presentation, you say visits to the grocer are just under 2x a week.

1.7.

There you go. How often does that Rocher softer cross-shop to the small shops that it's leased up against?

So it's not a consistent thing like always does this. But the non-grocery retailers that are in our sound and our neighbors, they are -- they see that as a major driver for their bone. Now, each retailer is a little different because some are very destination and they don't rely on that, but most of them have some very positive cohabitation sort of -- it's fundamentally making the shopping experience easier to handle your necessity goods, which is what our centers do -- and we're within 3 miles of your house. So it's a really convenient way to do that. And so you tend to either go first and get your card on and then go to the grocery or you go and you work out and then you buy groceries afterwards. Those are -- that is a very typical interaction in our center and a big driver of why the small store retailers want to be near the grocer. It's that -- it's just convenience to add something on to your 1.7x when you're at the grocer.

Okay. And then maybe I'll get something John involved here.

Don't go on to speak...

I'm good. I'm fine.

The first part will like PECO’s net debt-to-EBITDA is 5.5%. So very attractive. But your target is low to mid-6s. How do you plan to take advantage of this extra capacity and flexibility?

Thank you for that question. So our balance sheet, we raised some equity at the end of the second quarter, and that allowed us to return our leverage back to the level it was at the IPO. And so we said as part of our IPO just over a year ago that we had the capacity by $1 billion worth of assets over 3 years. which, by the way, we are on target for. We've acquired about $375 million. But now what we've done is brought our leverage back to a point where now we've replenished that $1 billion. And so we think we continue to have that opportunity to increase our leverage over time and add external growth that will then also fuel some of the organic growth because we had been targeting assets with an 8% unlevered IRR. And now given the market changes, we've raised our own internal hurdles and moving that to now more in the 8.5% to 9% IRR range. So what the balance sheet does is it gives us the ability to continue that runway. We are going to be patient in doing that, but we still believe we can achieve that over the 3 years.

And in addition to acquisitions, Craig, I mean, we'll use the balance sheet capacity for growth on-site redevelopment opportunities where -- and redevelopment for us is pretty low risk on a relative basis. I mean, what we're doing is typically building either a Starbucks or a Chipotle and outparcel, and that lease is in place prior to the construction starting or where you have a center that's very well leased where we know there's leasing demand that we can't accommodate, and we're building additional small shop space. And the yields on that development for us have been very attractive relative to what we can get in the acquisition market. And so we will continue to be very focused on looking for those redevelopment opportunities. And we think to date, we've said we'll do circa $50 million of that year. We're looking to be able to grow that given the relatively attractive yields we can get on that. vis-a-vis acquisitions.

And to your point, occupancy is high. So adding that GLA because there continues to be demand for space.

And one of the ways we're getting that growth is partnering with our grocers, and we're in early stages with the first [ Grover ] partnership where we will actually be using part of their parking lot and our parking lot, getting their approval for an expanded small store building. And that there's tremendous opportunity in the parking lots of our shopping centers to add that expanded retail. And it's complicated because you've got to have the right grocer or relationships because it is -- it's a really difficult approval process without it. And so it's truly a partnership, you got it. It's revenue sharing, sharing all the rest that you have to work through. But we're pretty optimistic that's going to become something that we can systematically add to a lot of our centers.

And is -- are the municipalities lowering your parking ratios? Or is it an that's just available on your site?

It's a little bit of both. I think the 5 1, which was historically the development thing is really -- has come down. And so there are municipalities where it's more like 4:1 and even some that are 3:1. Most of the times, that's actually driven by the operating side of the grocer who run the true operations of their store. And they're the ones where the -- more than the cities are the biggest constraint.

Okay. Just check and see any questions in the field? Okay. I assume that means you love the question so far. PECO just recently raised its dividend, about 0.0933% from 0.09%, an increase of 3.7%, but your dividend yields in the low 3s, -- your peers are pretty much in the floor. Is there any thought -- and I realize it's the Board decision. But was there any thought of maybe raising your dividend yield to be more in line with your peers?

Yes. We looked at that. And what we want to grow our dividend like we grow our cash flow, and we want them to be consistent. We have a -- we generate about $100 million of free cash flow a year on top of the dividend. And we've got really good uses for that. I think that we would change that more if there were not -- if those opportunities were to be less. Right now, we can put that -- those dollars to work at, we think, really strong returns. And so we anticipate keeping a similar ratio -- payout ratio of our cash flow in terms of the dividend. And we would -- what we've told our investors is primarily that we want to make sure we are a consistent growing dividend just being at a point where you were a high payout ratio might put you at risk of that. We have the ability to continue to grow our dividend over a long period of time. And we will try and match that primarily with our cash flow growth as well.

So sticking with your conservative nature?