Stage Set for Dividend Growth at Realty Income

 Realty Income Corporation (O) reported solid third-quarter results that included continued improvement in its dividend coverage, which we think sets up 2012 for at least mid-single-digit dividend growth.

For the quarter, on a year-over-year basis, revenue increased 24% and EBITDA increased 25%. Both were driven by a yearlong spending spree on cash-flow accretive acquisitions that increased the book value of revenue-generating assets by $1.1 billion, or nearly 30%. On a same-store basis (a measure of internal performance), rents increased 1.8%, which is within our range of normalized expectations for Realty Income, suggesting its portfolio is stable. Despite this, however, sixth-largest tenant Friendly's Ice Cream (3.6% of annualized revenue) recently filed for bankruptcy, and Realty Income management is budgeting for another 5% of revenue to file in 2012. Generally the firm's experience is quite good when one of its tenants files for bankruptcy, which has happened 24 times since its IPO in 1994. Realty Income aims to own its tenants' most profitable stores, and this protects it somewhat when a tenant restructures through bankruptcy, as tenants are incentivized to keep profitable stores open (and keep paying rent to Realty Income). While bankruptcies inevitably involve some store closures and rent reduction even at Realty Income's properties, we expect the potential financial impact to be muted.

Although reported occupancy improved to 97.7%, up 40 basis points sequentially, we attribute the majority of this improvement in occupancy to the disposition of vacant assets as opposed to improved leasing productivity.

Cash flow continued to grow at a rate that exceeds the rate of growth in Realty Income's dividend, improving the cash-flow coverage of dividend payments. Management's (and our) preferred cash-flow coverage metric, dividends/adjusted funds from operations, improved to 86% from 93% last year. Management's preferred payout range is between 85% and 90%. With this metric near the low end of that range, combined with our expectation of high-single-digit growth in AFFO in 2012, we expect at least a mid-single-digit dividend increase in 2012, up from sub-1% annual increases lately.

Its solid strategy, narrow moat, conservative approach to business, and impressive management team make Realty Income one of our favorite companies, although its stock trades roughly in line with our estimate of its fair value.

Realty Income's CFO, Paul Meurer, will be speaking at Morningstar's Management Behind the Moat Conference on Nov. 9, and we expect to post a video interview with him shortly thereafter.

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