As I have noted many times before over the past two years that I have wrote articles here on Seeking Alpha, it is important for investors to focus on dividend stocks with track records of increasing their dividends through good and bad operating environments alike.

One such example of a dividend stock that has managed to increase its dividend regardless of the operating environment that it found itself in is the Dividend Champion, National Retail Properties (NNN), which recently raised its dividend for the 31st consecutive year.

As I’ll discuss below for the first time since I covered the stock in July, National Retail Properties’ (hereafter referred to as NNN) relatively safe dividend, durable operating results in light of COVID-19, ~99% occupancy rate, long-term AFFO/share growth potential, and attractive current stock price all provide legitimate reasons for me to maintain my buy rating on shares of NNN despite the risks associated with an investment in the stock.

The Dividend Remains Covered Despite COVID-19 Headwinds

While I believe it is always important for investors to examine the safety of a stock’s underlying dividend, I believe it is especially important to do so when a stock’s yield is numerous times higher than the S&P 500’s current 1.69% yield as is the case with NNN’s current 6.08% yield.

This is precisely why I’ll be gauging the safety of NNN’s dividend by comparing its AFFO/share against its dividend/share payout.

Through the first half of this fiscal year, NNN generated $1.20 in AFFO/share (per page 1 of NNN’s Q2 2020 earnings press release) against $1.03 in dividends/share paid during that time, for an AFFO payout ratio of 85.8%.

While this is significantly higher than NNN’s 72.5% payout ratio through the first half of last fiscal year (as per data sourced from page 1 of NNN’s Q2 2020 earnings press release and the stock’s dividend page), it’s encouraging that even in the midst of a global pandemic, NNN’s AFFO payout ratio is only slightly elevated for a REIT.

The fact that NNN’s payout ratio is still reasonably well covered in spite of the COVID-19 challenges that it has endured in the first half of this year, and that NNN is poised to experience a gradual rebound in its operating fundamentals in the second half of this year (more on that in the next section) lead me to believe that NNN’s dividend remains safe for the foreseeable future.

I believe that given NNN’s mildly elevated AFFO payout ratio, NNN’s dividend growth over the long-term will slightly lag behind my annual AFFO/share growth forecast of 4.0-5.0%, which is why I am lowering my annual dividend growth rate for shares of NNN from 5.0% to 4.5%.

Fair Operating Results In Light Of The Business Environment

Source: NNN September 2020 Investor Update Presentation

Given that the second quarter of this year was characterized by widespread lockdowns due to COVID-19, I would argue that NNN’s second quarter results were satisfactory.

NNN’s revenue declined 0.7% YoY from $164.8 million in Q2 2019 to $163.7 million in Q2 2020 (as per page page 1 of NNN’s Q2 2020 earnings press release).

Despite the significant lockdowns that persisted through much of the second quarter, NNN’s occupancy rate declined only 10 basis points from 98.8% in Q1 2020 to 98.7% Q2 2020, as indicated by CFO Kevin Habicht’s opening remarks during NNN’s Q2 2020 earnings call.

NNN’s AFFO/share declined 29.0% YoY from $0.69/share in Q2 2019 to $0.49/share in Q2 2020 (as outlined on page 1 of NNN’s Q2 2020 earnings press release).

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Throughout the first half of this fiscal year, NNN’s revenue advanced 3.1% YoY from $328.5 million in H1 2019 to $338.8 million in H1 2020 (as demonstrated on page 1 of NNN’s Q2 2020 earnings press release).

Furthermore, NNN’s AFFO/share declined 13.0% YoY from $1.38 in H1 2019 to $1.20 in H1 2020 (as indicated on page 1 of NNN’s Q2 2020 earnings press release).

Due to the uncertainty that has been associated with the COVID-19 pandemic, NNN’s management team understandably reduced its acquisitions from ~$67 million in Q1 2020 to just ~$7 million in Q2 2020 at a 6.9% weighted average cap rate as indicated by CEO Jay Whitehurst’s opening remarks in NNN’s Q2 2020 earnings call.

Source: NNN September 2020 Investor Update Presentation

As one could imagine as a result of the widespread lockdowns in the second quarter, NNN’s rent collection rate came in at 69% as noted by CEO Jay Whitehurst’s opening remarks during NNN’s Q2 2020 earnings call, which largely contributed to NNN’s challenging second quarter.

Fortunately, for NNN, the company was able to collect 84% of its rent in July, which is a significant acceleration from the 69% rent collection rate during the second quarter as CEO Jay Whitehurst indicated in NNN’s Q2 2020 earnings call, and bodes well for the company’s second half results in terms of revenue, AFFO, and AFFO/share.

From a balance sheet perspective, NNN maintained ~$225 million in cash at the end of the second quarter, which is more than enough for the foreseeable future to fund NNN’s operations, especially considering that NNN faces no maturities until 2023 as indicated by the above slide.

Source: NNN September 2020 Investor Update Presentation

Given NNN’s ample cash position and the fact that NNN maintains $900 million in unsecured bank credit lines as illustrated by the slide above, it should come as no surprise that NNN maintains BBB+/Baa1/BBB+ investment-grade credit ratings from the major ratings agencies.

Moreover, NNN is comfortably meeting its unsecured credit facility key covenants, even in the midst of a challenging business environment.

NNN’s leverage ratio of 0.37 is well below its maximum leverage ratio of 0.60 as outlined in the company’s debt covenants, which bodes well for the company’s credit ratings going forward.

NNN’s minimum fixed charge coverage ratio of 3.96 is significantly above the minimum fixed charge coverage ratio of 1.50 as required by the company’s debt covenants, which is further evidence of NNN’s strong balance sheet.

NNN’s unencumbered asset value ratio of 2.74 is much higher than the 1.67 ratio that is required by NNN’s debt covenants.

Finally, NNN’s unencumbered interest ratio of 3.99 is significantly above the 1.75 ratio that is required by NNN’s debt covenants.

When taking into consideration NNN’s operating results in a challenging operating environment, NNN’s favorable rent collection trend going into the second half of this year, and NNN’s ample liquidity/strong balance sheet, I believe that NNN is capable of being a great long-term investment if shares are acquired at or below their fair value.

Risks To Consider:

Even though NNN is a high-quality business, that doesn’t mean that NNN is immune from risks, which is why I will be reiterating NNN’s risks outlined in its most recent 10-Q.

The first risk facing NNN is although the company expects to collect on 94% of the rent that was deferred in the second quarter by the end of next year (which was 21% of NNN’s rent due in the quarter) according to CFO Kevin Habicht’s opening remarks during NNN’s Q2 2020 earnings call, it is possible that additional lockdowns prompted by additional spread of COVID-19 could result in less rent being repaid by the end of next year than the company expects.

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Additionally, another lockdown would likely lead to more rent being deferred, a decline in NNN’s occupancy rate, and as a result, increased renovation expenses to draw in new tenants and at least a temporary loss in revenue, which would materially harm NNN’s financial results (page 38 of NNN’s most recent 10-Q).

Yet another notable risk facing NNN is that while NNN’s employees have been able to work remotely throughout most of this year with the advent of COVID-19 without operations being unfavorably impacted, it is worth noting that remote work has never been adopted at the scale that it has been over the past 7 months.

While I believe that NNN will be able to continue operating remotely without any notable interruptions to its operations (page 26 of NNN’s most recent 10-Q), there is no guarantee that the remote work environment that NNN has adopted will be able to continue for the duration of COVID-19 without unfavorable developments to NNN’s operating and financial results.

Although I have discussed several key COVID-19 related risks facing an investment in NNN, the above shouldn’t be interpreted as a complete discussion of NNN’s risk profile. For a more thorough discussion of the risks associated with an investment in NNN, I would refer interested readers to pages 7-16 of NNN’s most recent 10-K, pages 38-39 of NNN’s most recent 10-Q, and my previous articles on the stock.

A Dividend Champion REIT Trading At A Discount

Although NNN is a Dividend Champion with a dividend history rivaled by very few REITs, it remains key for investors to avoid overpaying for shares of the stock in order to minimize the risks of a lower starting yield, valuation multiple contraction, and lower total return potential, which is why I will be using two valuation metrics and a valuation model to arrive at a fair value for NNN’s shares.

The first valuation metric that I’ll be utilizing to determine the fair value of shares of NNN is the TTM dividend yield to 13-year median TTM dividend yield.

As indicated by Gurufocus, NNN’s current TTM yield of 6.04% is well above its 13-year median TTM yield of 4.61%.

Assuming a reversion in NNN’s yield to 5.00% and a fair value of $41.30 a share (which I believe adequately weighs the risks facing NNN at this time), NNN’s shares are trading at a 17.2% discount to fair value and offer 20.8% upside from the current price of $34.19 a share (as of October 18, 2020).

The next valuation metric that I will use to estimate the fair value of NNN’s shares is the price to book ratio to the 13-year median price to book ratio.

As per Gurufocus, NNN’s current P/B ratio of 1.49 is significantly lower than its 13-year median P/B ratio of 1.92.

Factoring in a middling P/B ratio of 1.70 and a fair value of $38.88 a share, shares of NNN are priced at a 12.1% discount to fair value and offer 13.7% capital appreciation from the current share price.

Image Source: Investopedia

The valuation model that I’ll be utilizing to assign a fair value to NNN’s shares is the dividend discount model or DDM.

The first input into the DDM is the expected dividend/share, which is another term for the annualized dividend/share. NNN’s annualized dividend/share is currently $2.08.

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The next input into the DDM is the cost of capital equity, which is the annual total return that an investor requires from their investments. While this rate typically differs from one investor to the next, I require 10% annual total returns from my investments because I believe such returns offer ample reward for the time and effort that I put into researching investment opportunities and periodically monitoring my investments.

The third input into the DDM is the annual dividend growth rate over the long-term or DGR.

Although the first two inputs into the DDM require little more than data retrieval to find the annualized dividend/share and subjectivity to arrive at an acceptable annual total return rate, accurately predicting a stock’s long-term DGR requires an investor to factor in numerous variables, including a stock’s payout ratios (and whether those payout ratios are positioned to remain the same, expand, or contract over the long-term), annual AFFO/share growth potential, the strength of a stock’s balance sheet, and industry fundamentals.

When I factor in that NNN’s AFFO payout ratio year to date is a bit above where I envision it will be over the long-term, that I anticipate mid-single digit AFFO/share growth over the next decade from NNN, and that NNN’s balance sheet is investment-grade, I believe that NNN’s dividend growth is positioned to lag its annual AFFO/share growth, which is why I believe a 4.5% annual dividend growth rate over the long-term is a reasonable expectation for shares of NNN.

Using the inputs above for the DDM, I arrive at a fair value of $37.82 a share, which indicates that NNN’s shares are trading at a 9.6% discount to fair value and offer 10.6% upside from the current share price.

When I average the three fair values above, I compute a fair value of $39.33 a share, which implies that shares of NNN are priced at a 13.1% discount to fair value and offer 15.0% capital appreciation from the current share price.

Summary: NNN Offers A Nice Blend Of Yield And Total Return Potential

While NNN’s most recent dividend increase of 1% is well below its 5-year average annual dividend growth rate of just over 4%, the mere fact that NNN was confident enough to increase its dividend in this operating environment coupled with NNN’s 31 consecutive annual dividend increases is the ultimate testament to NNN’s quality as a business.

Expanding on NNN’s quality as a business, is the fact that even in one of the most challenging operating environments in its 36-year corporate history, NNN’s AFFO/share declined YoY by barely a double-digit percentage margin through the first half of this fiscal year.

Add in NNN’s investment-grade balance sheet, and the case for NNN from a fundamentals standpoint alone is fairly strong.

The final strength for shares of NNN is the fact that my average fair value estimate demonstrates that NNN is trading at a 13% discount to fair value.

Between its 6.1% yield, 4.0-5.0% annual AFFO/share growth potential, and 1.4% annual valuation multiple expansion, shares of NNN are positioned to exceed my 10% annual total return requirement over the next decade.

It is with the foregoing reasons in mind that I elected to reiterate my buy rating for shares of NNN at this time.

Disclosure: I am/we are long NNN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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