Wednesday, February 6, 2008

Is Realty Income (O) a good stock to own?

I was browsing through yahoo finance, and I read an article about a real-estate investment company which has paid increasing dividends for 451 straight months. I looked at the monthly dividend payments over the past 10 years, and they looked promising for a real-estate investment trust. It looks very appealing to receive monthly dividend payments, as opposed to the quarterly ones that almost all dividend achievers worth their salt are paying these days. The dividend growth looked ok at an average of 5.21% annually over the past 10 years and an average of 6.46% annual dividend growth over the past 5 years. The major contributor for the growth is the 13% dividend hike in 2005. Without it, the growth would have been below my 5% dividend growth criteria. It also seems that the company is trying to raise its dividend three to four times per year, which is also a bonus.

I was seriously considering adding this company to my portfolio until I looked into the 10 year trends in its balance sheet, cash flow and net income statements. Looking at the income statement , it seemed that the annual income had tripled from 41.3 million in 1998 to 139.9 million in 2007. The number of shares outstanding had almost doubled though, from 52 million in 1998 to a whopping 92 million in 2007, which was bad news for EPS growth. Earnings per share increased at a slower pace, from 0.78 in 1998 to 1.18 in 2007. After looking at the cash flow statement though, it seemed that the company is financing its capital spending exclusively through debt origination and stock sales. That’s diluting existing shareholders’ interest in the company. It also seems that the growth in the cash flow from existing operations is due to the increased leveraging of the business. The Long-term debt portion of the balance sheet has increased from 110 million in 1997 to 1.47 billion in 2007, which is a 13 fold increase. At the same time the total equity has increased only 3.5 times, from 433 million in 1997 to 1.551 billion in 2007. In addition, the ratio of cash flow from operations to net PPE, which shows the return on investment that the company is generating per dollar of property that it owns has decreased from 9.01% in 1997 to 6.48% in 2007. This indicator does fluctuate between 6 and 12 % normally. It shows that the company cannot operate effectively if there is any large turbulence in the debt and equity markets where it obtains its financing. If these sources of capital dry out for O, then stockholders would expect flat to slightly down EPS.

In conclusion, although the company has managed to increase its dividends and revenues over the past 10 years this is primarily due to the increased use of outside capital from debt and equity markets. This dilutes stockholders equity over the long run and might lead to smaller EPS growth. The huge increase in debt relative to owners’ equity is definitely a red flag for me. If management slows down its debt accumulation and stock sales in order to obtain financing, the company might be in trouble, because its earnings growth will suffer. Even though the yield looks very attractive, the dividend growth is sluggish. In addition, the dividend payout ratio for O and REITs in general is above my 50% rate, which leaves the dividend rate exposed to fluctuations in the company’s earnings. The P/E ratio is above 20, which is a little pricey for me. Thus I would not own this stock at this time.

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