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

Good morning, everyone, and welcome to our conference meeting with Phillips Edison & Company. Phillips Edison is one of the nation's largest owners and operators of omnichannel grocery-anchored neighborhood shopping centers. With us today, we have Devin Murphy, President; and John Caulfield, CFO, Treasurer. But before I turn it over to management for its opening remark, I want to remind everyone that if they want to ask a question, please use the Veracast software to input your questions at the bottom of the screen. We will be looking for these questions and asking them on your behalf. Also, the audience can access the slides from Veracast. At this point, I will pass it on to Devin to start us off with an introduction overview of Phillips Edison. Devin?

Great. Thank you. Good morning, everyone. Thanks for being with us this morning. I look forward to highlighting Phillips Edison with you over the next 30 minutes. So I'd like to highlight 4 points that we believe differentiate Phillips Edison. We have a focused and differentiated strategy. At Phillips Edison, we focus exclusively on owning and operating grocery-anchored neighborhood shopping centers. Each of our centers are anchored by a grocer that is the #1 or #2 grocer in its market, and our tenants are providing necessity-based goods and services to their customers. We have a fully integrated operating platform that we've built over the last 30 years, and we control every aspect of the shopping center ownership process. Our team is cycle-tested and aligned with shareholders. Our management team owns over 7% of the equity of our company. We have a national strategy and a strategy that has substantial scale. We own over 290 centers in over 30 states. Our centers are smaller format neighborhood centers that are anchored by the 1 or 2 grocer in the market, and they're located in markets where our top grocers can perform successfully. Our focused strategy has resulted in superior operating performance through all cycles, ups and downs. We have posted industry-leading performance pre-pandemic, through the pandemic and post-pandemic. And we fully expect to continue to outperform as we go forward. We're very excited about the current environment that we find ourselves in. And we believe that there are exciting growth opportunities that we will be able to take advantage of. If you'll turn to the next slide in our deck. Our differentiated strategy is primarily based on the fact that we are exclusively focused on owning and operating grocery-anchored neighborhood shopping centers. 96% of our ABR comes from shopping centers that are anchored by a grocer. This is the highest percentage of grocery-anchored centers of any of the public REITs. 86% of our ABR comes from shopping centers that are anchored by the 1 or 2 grocer in their market, again, an industry-leading statistic. We believe strongly that format drives results. Our shopping centers are the smallest average center in the market, and we believe that this scale gives us superior leasing leverage as we lease our centers. There are a number of reasons for this. #1, our average small shop space is under 2,500 square feet. And over 65% of the leasing volume in shopping centers is in formats that are less than 2,500 square feet. So our centers align well with where retailer demand is coming from. #2, we have less exposure to the larger format retailers where the economics are less attractive to the landlord. Our centers have proven to be a last-mile solution for our retailers. And they're located in trade areas where our leading grocers and small shop tenants can be successful. If you'll turn to the next slide in your deck. We've been focused exclusively on grocery-anchored shopping centers since our inception over 30 years ago. We believe that grocery-anchored shopping centers are the best-performing segment in the retail shopping center environment. There are a number of reasons for this. #1, grocery retail is necessity-based. 73% of our ABR comes from tenants that are providing necessity-based goods and services to their customer. This strategy has performed well in all cycles, ups and downs. We noted in the pandemic that we were highly resilient and we had limited exposure to distressed retailers. Less than 1% of our ABR came from retailers that were among the top 15 retailer bankruptcies in 2020. Top grocers generate high recurring foot traffic to a shopping center. The average American goes to the shopping center went close to the grocer 1.6 times a week, by far and away, the largest repeat traffic to any type of retail. The average PECO center gets almost 20,000 customer visits a week. This strong recurring foot traffic to our centers allows our in-line tenants to thrive and allows us to successfully grow rents. We've noted that our tenants are successfully evolving into omnichannel retailers. And PECO centers have become a critical component of our neighbors, we call our tenants neighbors, omnichannel strategies and provide an attractive last-mile solution to our neighbors. Over 90% of the PECO portfolio today offers each and every one of our neighbors the opportunity to offer BOPIS, buy online, pick up in store, to their customers should their customer choose to pursue this form of shopping. We believe that the economics of bricks-and-mortar retail in the grocery business are compelling because grocery delivery offers an attractive economics to the grocer and the customer has shown to have a preference for the convenience of pickup versus online delivery to the home. If you'll turn to the next page. We believe our differentiated focus has driven superior risk-adjusted returns over time. Our acquisition strategy allows us to enjoy more attractive going in yields, our markets yield, going in yields 50 to 100 basis points higher than the yields available in more competitive coastal markets. We've demonstrated over time an ability to grow our same-store NOI faster than the industry average. If you look pre-pandemic, we were able to grow our same-store NOI at over 100 basis points faster than the sector. And then lastly, for a number of reasons, one of which is the fact that we enjoy industry-leading retention rates, is that our assets require lower CapEx. The combination of these factors: higher going-in yields, higher growth and less CapEx, results in superior investment returns. So hopefully, you'll take away this morning from our conversation with, the fact that we own neighborhood centers anchored by the 1 or 2 grocer that are providing necessity goods to its customer base. We have a large portfolio at scale and we own centers where the leading grocers are able to be successful. We have an experienced, cycle-tested team that's well aligned with shareholders, owning over 7% of the company. And the future growth prospects that we foresee are very attractive given the strength of our balance sheet that will allow us to drive attractive external growth. Our bricks-and-mortar centers support our neighbor's omnichannel efforts and are both complementary and resilient to e-commerce. Our strategy has resulted in superior operational and financial performance over time. And we fully expect that we will be able to drive this type of outperformance on a go-forward basis. And we're very excited about the prospects that the current environment offer to us. Craig, back to you.

Great. Thank you. This summer, this past summer really showed a benefit to retailers and landlords. We saw higher traffic, higher sales and improved leasing metrics. I'm wondering if the Delta variant and the rise in COVID cases had any impacts on your traffic? And are you seeing any hesitancy from retailers leasing new space given the Delta variant?

So Craig, we use a service that a lot of our competitors and retailers use, call Placer.ai, which tracks foot traffic to centers using cellphone data. And we've got data through August. And in July and August, comparing the foot traffic at our centers to the foot traffic at those same centers in 2019, so that we are not seeing any falloff from the consumer. In fact, the foot traffic at those centers was high single-digits higher than it had been in the comparable period in 2019. So the consumer is continuing to be active at our centers, visiting our centers and spending money at our centers. And that's translated into leasing activity that, as we've announced in the first and second quarter, were at record levels, and we're not seeing any falloff in that leasing activity in the third quarter. And we believe that our third quarter leasing activity will compare favorably to what we were able to put up in the first and second quarter. So knock on wood, to date, we have not seen a falloff due to Delta, and hopefully, that will hold.

And on these elevated leasing volumes, is it because there's a growing universe of tenants that are looking for space? Or are you stealing market share from some of your competitors?

I think it's a number of factors, Craig. I think, #1, that as you know, the supply-demand dynamic in our business is extremely favorable to existing inventory. There's virtually no new supply being delivered. And there is increased demand from retailers, and it's coming in several ways. #1, we're seeing retailers that have historically been tenants in Phillips Edison centers, like a Starbucks and a Chipotle, seeing the current wave of increased suburbanization occurring. And they want stores located in these communities where people are spending more time given work from home, et cetera. And so we've seen a dramatic uptick in national retailers, such as Starbucks, Chipotle and others, that are increasing their tenancy in our portfolio. #1. #2, we're beginning to see tenants that historically have not been tenants in our centers. They were primarily mall-based tenants. These are tenants like Pearle Vision, LensCrafters, et cetera. And they are now beginning to lease space in our centers. So the combination of virtually no new supply and a high level of demand from new demand cohorts is attractive. And then lastly, we enjoy retention rates in the high 80s. Our -- almost 9 out of every 10 of our tenants when a lease comes up for renewal is renewing their lease with us, which is proving that they're enjoying success in our centers. And so the combination of limited inventory, high retention and new cohorts of demand is allowing us to have a very attractive leasing environment.

Great. And then I mean, we've also noticed that store closings have been unusually benign in '21. I'm sure some of this was a pull forward from 2020. But do you see this trend continuing into 2022? And why are we seeing so few store closings this year?

Well, as you know, we had a high level of bankruptcies in 2020. And so the weak retailers were basically weeded out in 2020. And therefore, the ones that were not able to make it have, in essence, gone away. The good news for us at Phillips Edison is, given the fact that our portfolio is focused on necessity-based retailers who are able to outperform in the pandemic given the fact that they were selling necessity goods and not discretionary goods, we had less than 1% of our ABR associated with retailers that went bankrupt in 2020. And also, we have very limited exposure to the categories that had the highest level of bankruptcies. So as you know, the highest level of bankruptcies occurred in accessories and soft goods. And we have a very limited percentage of our ABR that comes from that type of tenant. And so my expectation is the bankruptcy level is going to continue to be stable on a go forward. And fortunately, the segment that we're in allows us to have much lower exposure to those retailers than other retail formats have.

Okay. And then PECO has identified 5,800 grocery-anchored properties in the U.S. that fits PECO's portfolio strategy. Could you describe a little bit about the process of identifying lease target acquisition?

Sure. What we've done, Craig, is we've looked at the entire universe of shopping centers in the U.S. and we'd looked for centers that meet the criteria that we're focused on, anchored by the 1 or 2 grocer that are rightsized and that have a demographic profile that allow top grocers to be successful, both in terms of density and incomes. So when we run the screen using those criteria, we come up with a total of 5,800 centers in the U.S. that meet that criteria. And the way we employ our disciplined process is, we have a dedicated acquisitions team, made up of 6 professionals that are highly experienced. And they rely not only on their experience and their relationships, but we also have a proprietary tool that we employ in our acquisition process called the PECO POWER SCORE we've developed over the years. And what the PECO POWER SCORE allows us to do is to appropriately weight the characteristics of centers and not overweight a characteristic in error or underweighted characteristic in error. The POWER SCORE has over 45 data points that it employs. And we've, over time, reviewed over 4,000 assets in the last 5 years that, that data goes into the POWER SCORE. So it's a very powerful tool that when combined with the experience of our senior management team as well as our transactions team allows us to be highly disciplined in the acquisition process. And we believe that on an annual basis, approximately 10% of that acquisition market is available for acquisition. So round numbers, 580 centers a year, we trade. We would need to acquire approximately 14 out of that 580 to meet our acquisition objectives that we've articulated to the market, which is between July 1 of this year and June 30, 2024, will acquire $1 billion of assets. We're highly confident we will hit that metric. For the second half of 2021, we've indicated that we will acquire between $160 million and $200 million of centers that meet our criteria, and we're very confident we will meet that objective. And when we announce our acquisition results, investors will be pleased. Again, we're looking for centers anchored by the 1 or 2 grocer, that have appropriate demographics and that are yielding an 8% unlevered IRR. We are an IRR-based buyer, not a cap rate-based buyer. And the metric that we lean most heavily on is that unlevered IRR.

Great. And then how has the transaction market changed over a year ago? And are you seeing more product brought to the market for sale?

Yes. So the market was limited, Craig. Up until first or second quarter of this year, there was very little volume. And what that caused to happen is cap rates compressed. And we believe that in our markets, we saw cap rates compressed approximately 50 basis points from where they were previously. What that cap rate compression cause to happen is an increase in centers available in the markets. So we've seen opportunities to acquire assets increase pretty dramatically in the last quarter. And we believe that that's going to continue because cap rates have basically stabilized at this lower cap rate level. And so we're again seeing a large number of opportunities that meet our criteria and that we believe we'll be able to generate the 8% unlevered that we're targeting.

Okay. And then if we could talk about your net debt-to-EBITDA ratio, where are you now? And what ranges are you comfortable operating in for the net-debt-to-EBITDA?

Sure, I'll take that. So pro forma for the IPO, we're approximately 5.5x on a debt-to-EBITDA basis, which puts us among the lowest in the shopping center sector, sorry. What this allows us to do is take the organic growth that we've been able to generate historically and continue that forward, but add an external growth component. As Devin said, that we have -- we've said that we plan to buy $1 billion of assets. And he just talked about the market opportunity out there, and we are able to find these. So we're going to add $1 billion. That will increase our debt to EBITDA. But we are an investment-grade rated balance sheet, and we are committed to maintaining that. So we're at 5.5x. And we believe that we can buy the $1 billion of assets and stay with a target level in the low 6x to 6.5x on a debt-to-EBITDA basis. We're BAA3 from Moody's and BBB- from S&P, and believe that in our conversations with them, similarly, that we are able -- we'll be able to maintain that investment-grade rating.

And Craig, one of the other points, in addition to the fact that we have an attractively levered balance sheet and one of the lowest debt-to-EBITDA metrics in the space, is the fact that we are generating a meaningful amount of free cash flow on an annual basis, over $80 million a year. So in addition to the debt-to-EBITDA level that we have, we also are generating a meaningful amount of free cash flow that we can use to employ. And so that's why the combination of those 2 things allow us to be able to acquire this $1 billion of assets without having to come back to the equity markets.

Okay. What do you expect for your trend of bad debt reserve in the third and fourth quarter of this year?

So I'll take that again. So what we've seen is that our collection are essentially at pre-COVID levels. I mean we have -- we're over 98%. We've collected a significant portion of 2020 as well as in 2021. So we are approaching stabilized levels on a bad debt basis. And I actually think that, I believe in the second quarter, we talked about, on the back half of the year, potentially $2 million or so that will be kind of out of period in into this -- into the back half here. But I mean, essentially, our rents and our go-forward, we believe, is stabilized. And our neighbors are open for business, and they're paying us rent.

Okay. And then just, are we getting to a point where we might start to see tenants go back to an accrual basis versus cash? Are you seeing that stabilization?

So I would say, yes. So we were about 8% on a cash basis at the end of the second quarter. And we have -- we kind of follow a strict criteria that really requires them to, I believe, be current on their outstanding balance for 3 consecutive months. And so I would expect a positive movement on that here in the third quarter as we move forward. We did not. We looked categorically. I know some of the -- some -- there's kind of a difference in practice. We tried to look and say, categorically, should we have certain uses that we should put on a cash basis? Well, we don't have any movie theaters. Our entertainment is less than 1% of our rent, and even restaurants. And so when we looked at it, our collections were just too good from our restaurant neighbors. And so we look at it on an individual neighbor by neighbor basis. But I do think that, that trend will improve.

Okay. And then every associate who's been with PECO over a year owns stock in the company. Do you have a higher retention rate of your talent given this share of the company?

Yes, we do, Craig. There are a number of things about us that we like to highlight. We've been named the best place to work in Cincinnati 5 years in a row. And that is an award that is based on a number of factors, including employee input on that metric. We also offer our employees a number of ways to become involved in the business. Several years ago, well, actually 7 years ago, we created something called PECO NOW, which is Networking Opportunities for Women, which gave the women of PECO the ability to network together and compare experiences and get to know each other, and leverage those relationships into providing them good opportunities within PECO for growth. And then more recently, we created something we call PECO MORE, MORE stands for Multicultural Opportunities, which is dedicated to furthering diversity and inclusion at PECO. So we have a very experienced team that has spent a large number of years with Phillips Edison. We enjoy a great level of retention in our company. And we believe it's because we view our employees as our most critical benefit...

Asset.

Asset. Thank you, John. As our most critical asset. And so the simple answer to your question, Craig, is yes.

Okay. And maybe what are your target volumes for annual development and redevelopment? And what are your projected yield?

Yes. So we are not a developer, Craig. We don't do greenfield development. We don't believe that the risk/reward of greenfield development appropriately reward you for the risk. The development that we do is primarily outlet, outparcel development, where when we have a center that's highly leased and we have the ability to add incremental in-line GLA at that center, we typically undertake a project to build incremental in-line space at that center. These projects tend to be $2 million to $4 million in scale. We believe we'll do $40 million to $50 million of this type of redevelopment a year. And we believe we'll generate unlevered cash-on-cash returns of $9 million to $11 million. So we view it as being very attractive risk reward. What we found is that these projects that we've done to date have been very well occupied as soon as they open. And it makes sense because we're typically not taking on these projects unless we're doing it at a center that has occupancy virtually at 100%. And we know from our leasing team that there's incremental leasing demand in the market. And that if we had incremental inventory to lease, it would lease.

Okay. And then what steps are you taking to ensure your assets are safe? And including in this cleaning regimen. And how do you communicate that your assets are safe to the consumer?

Yes.

Yes. Devin, why don't I take that one?

Yes. Go ahead. Fire away, John.

So in terms of safety, what we found is that through COVID, 100% of our centers were open. We have open air shopping centers of necessity-based goods and services. And as Devin referenced earlier, we're seeing great foot traffic that exceed 2019 levels to our neighbors. In terms of how we've helped facilitate that, we've worked with them to expand some of the restrictions that might have been around the common areas. We helped add outdoor seating. We helped -- we've put in Front Row To Go, which Devin talked about, which is a BOPIS solution that is in line with what our grocers do. So our grocers have click and collect as well. But also, this is one for our neighbors to do so that they could continue to deliver their goods and services to the people and the community. So that has gone really, really well, as evidenced by our foot traffic and our collections and our continued leasing demand. So we believe that our customers for our neighbors do feel safe and -- yes.

Okay. And I guess do you continue to believe we'll see M&A activity in the strip REIT space?

Well, we do. We believe that our strategy, Craig, is focused and differentiated. And therefore, it's probably less likely that we will be a participant in a large corporate transaction, given the fact that given our focused and differentiated strategy, there are very limited corporate opportunities that match our differentiated model. So therefore, we feel a corporate transaction is less likely for us. We've built this company over time asset by asset. We feel that's the way to build it. We found over time that portfolio transactions typically demand a portfolio premium. And when you break down the portfolio on an asset-by-asset basis, you're paying a premium for that portfolio over what you would have paid if you had built it asset by asset. And so our expectation is that we will look at all opportunities that become available to us. But unless the acquisition meets our disciplined focus, which is #1 or #2 grocer, neighborhood centers, the right demographic profile, we're going to be disciplined and only acquire assets that meet our criteria.

And we're very bullish on the opportunities on the asset-by-asset basis. I think that's the other part of it, is that we'll definitely look at it and consider, but we're able to deliver the growth that we've outlined following the methods that we currently employ.

Okay. And you've highlighted a number of differences between you and the other 17 script REIT. Which do you think is the most significant difference between you and your peers?

I think it's the exclusive focus on grocery, Craig. And then it's the focus on format. It's the combination of those 2 things. I mean we really believe that you want to want it set or anchored by the 1 or 2 grocer in a market and you want a center that's rightsized because that really gives you the leasing leverage that allows us to drive rents the way we have and be able to enjoy the market-leading same-store NOI growth that we have enjoyed historically. And we believe our business model will allow us to prospectively.

Okay. At this point, I'd like to turn to our rapid fire questions. We have 3 rapid fire questions. The first is, which of the following is the greatest challenge facing U.S. REITs today? A, Fed action and higher rates; B, supply chain issues, including labor and logistic; or C, flow to nontraded REIT?

Yes. I'll give my answer and then I'll let John weigh in with his. But to be honest, Craig, I don't lose any sleep over any of those 3 issues. If you ask me to pick which one I would lose the most sleep over, it would be the first one, which is, what happens to interest rates. It all depends on what's driving interest rates higher as to the degree of concern I would have. But if you ask me our #1 concern for our business, it would be our ability to successfully evolve through an omnichannel strategy. And we believe we're well on our way to that and believe that we will be successful in evolving in that manner.

Yes. No. I agree with that. I mean I would say our balance sheet is highly fixed given what we've done. But we believe that our neighbors, given the necessity-based goods and services, I mean, inflation will impact them. But I also believe that they'll be able to adjust prices. I don't believe at this time that it's impacted leasing or their sales to the point. I do think the supply chain will be impactful on costs. But I also think that hopefully, that's more of a temporary piece. But the inflation has the potential to be a longer run outcome as we await what happens tomorrow and the remainder of the year. From an interest rate perspective, I think that's more meaningful. But I do -- I agree with Devin very much, that we believe we're in a great position to weather any of these potential storms.

Okay. And then over the next 5 years, which market will outperform: urban coastal or Sunbelt?

Sunbelt.

Okay.

And by the way, just for the record, over 50% of our ABR comes from centers located in the Sunbelt. So that outsized growth, we believe, is a really positive thing for Phillips Edison.

Yes. I agree. I think that's one of the tailwinds that you're seeing, right, coming out of the pandemic, is an influx of people into different markets that we've been in for 30 years. I'm sitting in one right now in Cincinnati.

Okay. The third question, for your company's office plan, this is your company, office plans post-pandemic. Well, A, you have no changes from pre-pandemic; B, leave it up to the team; C, offer hybrid; or D, go full remote?

So that is a question that we are struggling with right now, Craig. And it's to be determined. My expectation is that it will be, C, hybrid. We'll go to a hybrid environment once we've made the decision.

And this gets to what Devin was talking about earlier with our culture. So we actually have an associate team, a cross-functional team that's discussing and evaluating the opportunity that we have on this very topic. So getting the employee feedback, associate feedback.

Great. Well, listen, we're at the end of our time. I want to thank Devin and John for agreeing to do this round table. And I hope they have a good rest of the year as well as a good rest of the conference.

Great.

Thank you very much.

Take care.

Thanks, Craig.

Bye. Take care.

Bye, everyone.