Investors searching for a large-cap stock with a solid and growing dividend might look at AvalonBay Communities Inc. (AVB, Financial). This 10-year chart shows the solid growth of dividend payments:
This comany is a REIT (real estate investment trust) that owned or held an ownership interest in 86,380 multifamily apartment homes in 11 states and the District of Columbia at the end of the second quarter of 2020. Approximately 19 of its facilities or "communities" were still under development as of the quarter's end.
The company is quite selective in choosing its markets, which are characterized by:
- Leading metropolitan areas
- Growing employment in high wage sectors
- Higher home-ownership costs
- Diverse and vibrant quality of life
In its 10-K for 2019, it stated, "We believe these market characteristics offer the opportunity for superior risk-adjusted returns over the long-term on apartment community investments relative to other markets that do not have these characteristics."
This 10-year chart of earnings per share shows that the strategy worked well in the middle of the past decade, but not so well in recent years:
Investors may be losing patience and/or considering the stock overvalued, despite the strong dividend, as the share price plunged with the rest of the market earlier this year but did not recover.
That may be, in part, because of the first-quarter results, which saw earnings per share drop by 3.3% from the same period in the previous year. Funds from Operations (FFO) were down by 1.3%, while Core FFO per share increased 3.9% from Q1 2019.
To further assess AvalonBay's prospects for the next five to ten years, let's take a look at its fundamentals, dividends and share buybacks.
Financial strength
This low rating for financial strength comes largely from the AvalonBay's debt situation. As the first line indicates, the company's cash-to-debt ratio has fallen compared to its history, and the summary page also provides a "Severe" alert about growing debt.
As this 10-year chart shows, long-term debt has been growing quickly:
Is it too much debt? According to the Interest Coverage ratio, the company's operating income only covers 3.84 times the cost of interest. Benjamin Graham, the father of value investing, recommended interest coverage of at least 5 times (at the absolute minimum).
The Piotroski F-Score and Altman Z-Score are edging toward the danger zones as well. The Piotroski F-Score is based on (1) Cash Flow Return on Assets, (2) Change in Return on Assets, (3) Change in Leverage, (4) Change in Shares in Issue and (5) Change in Gross Margin. Failing on five of the nine tests in the F-Score does not inspire confidence.
The GuruFocus system also issued a "Moderate" alert about the ROIC vs WACC ratio. The weighted average cost of capital is greater than the return on invested capital. In other words, it is destroying shareholder value.
Where does the capital go? Largely into new buildings or facilities that the company expects to deliver long-term earnings. Here are the highlights of 2019:
- Finished building seven apartment communities, to add 2,027 units and 34,000 square feet of retail space at a cost of $667 million.
- Started construction on eight "communities" that will add 2,377 new units, at a cost of $849 million.
- Wound up redevelopment of nine communities and 3,276 units at a cost of $136 million.
AvalonBay could, of course, grow its portfolio with cash flow alone, but debt allows it to accelerate that growth. Further, as the portfolio grows it take even bigger gulps to keep up the "growth" rate.
Profitability
That's a strong rating for profitability, and not surprising when we see its margin percentages are in the mid-30s. Judging by the colors of the bars adjacent to the margins, the company is not far from its own historical averages and industry averages.
AvalonBay's ROE is 7.22% and the ROA is 4.08%. Neither of these numbers is outstanding, but they are generally consistent with what the REIT sector is generating.
When we get to the growth section of the table, the last three lines, we see a problem. In the past three years, revenue has gone up, but profitability in the form of Ebitda and earnings per share have gone down.
Valuation
The company has a relatively attractive valuation rating, but we must remember that there may be a reason why the price did not recover with the overall market. As a result, the price is more attractive than it has been in the recent past.
Turning to specifics, at a price-earnings ratio of 27.51, the stock is still a bit overvalued compared to the industry.
The price-earnings-to-growth (PEG) ratio, based on the price-earnings ratio divided by the growth rate, comes in very high at 5.6.
On the other hand, the discounted cash flow (DCF) calculator shows it to be slightly undervalued based on the below assumptions:
Dividends
As we saw at the beginning of the article, AvalonBay is a serious dividend company, providing a dividend yield of more than 4%. The yield has been driven up by the recent price plunge:
The dividend payout ratio is high at 111%, but we must remember that this is a REIT, and thus by law must pay out at least 90% of its earnings. What if the payout is higher than 100%? As the Corporate Finance Institute explained:
"If a calculated ratio is over 100%, it means that the dividends of that REIT are higher than income projected for future operations. As a result, the REIT can be obliged to pay dividends from its cash reserve. However, such a scenario is not a cause for alarm if it prevails in the short term. It can, however, be a cause for alarm if it extends to the long term, which will be unsustainable for the business and will require swift action for the adjustment of dividends payout."
This chart shows AvalonBay has consistently paid out more than 100% every year for the past decade:
So, we should be seeing the REIT's cash and cash equivalents melt away, as it continues to pay out more than 100% per year, and that appears to have happened:
Thus, some of the debt may have been used to pay dividends.
The three-year dividend growth rate has an average of 4% per year, which helps drive the five-year yield-on-cost of 5.32% per year.
Finally, while the share buyback ratio shows a negative result, this chart of shares outstanding shows the company reducing its stock count by about 30%:
If you buy at the current, depressed price, you will get a dividend that is more than double the S&P 500 average. However, investors should be concerned about the cash drawdown and the potential use of debt to finance the dividend.
Gurus
AvalonBay was owned by nine of the gurus as of June 30. The biggest holding belonged to Jim Simons (Trades, Portfolio) of Renaissance Technologies, who held 528,214 shares after increasing his stake by a whopping 273%. That gave him a 0.38% ownership position.
Pioneer Investments (Trades, Portfolio) held 210,759 shares after reducing its holdings by 37.72% during the quarter.
Chris Davis (Trades, Portfolio) of Davis Selected Advisers held 87,230 shares after cutting back by 22.59%.
Conclusion
AvalonBay is a mixed bag of fundamental metrics and data. It receives a low rating for financial strength, yet the company uses that leverage to keep expanding its portfolio and earnings potential. A high rating for profitability comes up against lower Ebitda and earnings per share growth over the past three years. The valuation is rated moderately high, yet that's really only the case when we look at the recently reduced share price and not the price-earnings ratio or DCF calculation.
At the current price, the dividend is strong, but it appears to be taking up almost all of the company's available cash and equivalents.
I think AvalonBay may be an interesting short-list candidate for income investors looking for something in a REIT or real estate component. Growth investors might watch if the share price gets going again. Value investors will find the debt level and the small margin of safety disqualifying characteristics.
Disclosure: I do not own shares in any companies named in this article.
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