I started an audacious mission back in early 2010, at just 27 years old: I wanted to become financially independent by the time I was 40.
Starting out in debt (below broke), I knew I had to make some substantial life changes and develop an income source that was independent of a job (i.e. passive income).
[ad#Google Adsense 336×280-IA]So I started living extremely frugally, saving well over half of my net income, on average, for six years.
And the savings generated a nice capital base I could invest, which could bring about the passive income I needed to say goodbye to the day job.
I invest my excess capital into high-quality dividend growth stocks because I believe that any business that deserves my capital is one that is very profitable.
And I also want to see increasing profit over time.
But increasing profit does me little good if I have to sell my stakes in businesses to unlock income, so I like to invest only in businesses that directly send me my fair share of the growing profit they generate.
That means I stick to companies that pay me increasing dividends, like those you’ll see on David Fish’s Dividend Champions, Contenders, and Challengers list.
All of this saving and investing has resulted in the six-figure portfolio I now control. And the dividend income it generates started covering my core personal expenses at just 33 years old, rendering me effectively financially independent.
I naturally prefer companies that have multidecade streaks of increasing dividends, as that shows me they’re able to weather short-term economic storms.
But I sometimes run across businesses that have shorter track records that nonetheless appear to be really appealing long-term investment candidates.
Well, I put some capital to work in a very interesting company recently, and I wanted to share that idea with you readers.
I purchased 35 shares of Pebblebrook Hotel Trust (PEB) on 6/14/16 for $25.04 per share.
Overview
Pebblebrook Hotel Trust is a real estate investment trust that looks to opportunistically acquire and invest in hotel properties located primarily in major U.S. cities, with an emphasis on large gateway coastal markets.
The company went public in December 2009.
As of December 31, 2015, the company wholly owned 31 hotels and also had 49% joint venture interests in another 6 hotels.
Quantitative Analysis
The company is fundamentally excellent pretty much across the board.
While I usually like to look at 10 years’ worth of financial data, the company’s history doesn’t go that far back.
And because some key numbers were negative in 2010 (their first full year of operation), I’m going to use the five-year period from fiscal years 2011 to 2015 for top-line and bottom-line growth.
The company’s revenue increased from $288 million to $771 million over this stretch, which is a compound annual growth rate of 27.91%.
While obviously incredible, REITs issue shares somewhat regularly as a method of financing, which has a dilutive effect on the bottom line. As such, looking at profit on a per-share basis is more indicative of true growth.
And since REITs tend to record a lot of non-cash charges that can negatively and artifically impact profit, the accepted measure for industry profit is funds from operations (rather than earnings), which adds key charges back in. FFO is effectively cash flow for a REIT.
Adjusted funds from operations grew from $1.00 to $2.50 over this five-year period. That’s a CAGR of 25.74%.
It’s not all that often that you’ll find top-line and bottom-line growth almost mirror each other when looking at REITs. In my view, that’s a hallmark of a superior company that’s particularly adept at raising and deploying capital.
Now, as a dividend growth investor, one of my primary concerns is a company’s dividend policy. Specifically, I want to see a sizable dividend that’s growing at least in line with profit growth, and I want to see a longstanding demonstrated track record of that.
Well, Pebblebrook Hotel Trust certainly does not disappoint here.
While the company doesn’t have the requesite five-year dividend growth streak I look for as a minimum, I’m lenient due to their limited operational history.
They’ve paying a dividend since the end of FY 2010, which is when they started to become profitable. And they started aggressively increasing it starting in FY 2013.
How aggressive?
The dividend came in at $0.48 per share for FY 2012. The company is slated to pay out $1.52 this year. So we’re talking a CAGR of 33.4%.
Just huge dividend growth here, and most of it has been supported by monstrous AFFO growth.
And with a payout ratio of just 55.7%, there’s plenty of room for more dividend increases.
A payout ratio that moderate and a dividend growth rate that substantial are both incredible metrics when taken in tandem, but I think these numbers are even more impressive when considering the fact that the stock yields a very appealing 5.73% right now.
While REITs in general tend to offer big yields due to the fact that they legally have to pay out at least 90% of their taxable net income to shareholders as a dividend, it’s not often that you’ll find this unique combination of dividend growth, yield, and sustainability.
Rising interest rates could make this yield slightly less appealing, especially since REITs rely heavily on debt to finance growth. But I find the specter of rising rates to be overrated since rates are still so low.
Speaking debt, Pebblebrook Hotel Trust also sports a great balance sheet.
At the end of last fiscal year, total net debt came in at 4.7 times TTM EBITDA. The long-term debt/equity ratio stood at 0.63. The fixed charge coverage ratio was 2.9.
Profitability is solid, with same-property EBITDA margin at 33.1% last fiscal year.
Same-property occupancy finished at 84% for FY 2015.
Qualitative Analysis
Take a look at the cities that Pebblebrook Hotel Trust has exposure to: New York, Boston, Washington D.C., Miami, Los Angeles, San Francisco, Seattle.
These are major gateway urban markets on both coasts. Travelers – domestic and international – want to be in these cities. They’re cities that have been and very likely will continue to be very popular for a variety of reasons.
While some lodging trusts focus on middle-market properties, Pebblebrook Hotel Trust likes to own the best properties in the best locations in the best cities. For instance, their Hotel Zephyr Fisherman’s Wharf is basically across the street from San Francisco’s Fisherman’s Wharf. And that hotel is decorated to be uniquely San Francisco – not just another hotel in another city.
There are huge barriers to entry here – limiting competition – because of space, building, and regulation limitations. You can’t just freely build hotels in these cities.
What Pebblebrook Hotel Trust traditionally does is acquire overlooked, aging, and perhaps misused properties. These are properties in fantastic locations but in need of a little TLC. They then go in and renovate these hotels, using local flavors, creating a premium product with a premium experience. And they’re able to charge a premium price: same-property revenue per available room increased 3.3% last year to $205.42.
Meanwhile, the occupancy rate remains quite high. While some fear that Airbnb is going to somehow take over the world, Airbnb has been fully operational over the entire five-year period we just looked at earlier. Yet the company posted incredible numbers. I believe the clientele that Pebblebrook Hotel Trust caters to is unlikely to view someone’s spare bedroom as a suitable location for short-term vacation housing.
That said, the company is apparently finding it difficult to land the right properties at the right prices – acquisitions have slowed, and the company has actually unloaded some properties of late. As such, I view future growth to slow relative to what we’ve seen over the last few years where the company grew out of nothing. Of course, if pricing on some of these properties comes down, the company may be more aggressive with acquisitions. I view their prudence favorably.
Risks
The company is heavily dependent on the overall health of the economy in general and tourism specifically. If travelers aren’t spending time in these major urban gateway cities, Pebblebrook Hotel Trust isn’t filling rooms.
Moreover, their “tenants” are extremely short term in nature. Customers “rent” space for a very short period of time, and there’s obviously a lot of turnover there. This is the opposite of a REIT that locks in long-term contracts with tenants.
They lack a proven history through multiple economic cycles. The company went public just as the economy started to recover after the Great Recession; it remains to be seen how well their business holds up in a major recession.
If Airbnb becomes even more popular than it already is, this could increase competitiveness and demand for a limited clientele base.
Valuation
The stock is down approximately 40% over the last year. However, the business has most certainly not eroded by 40% compared to where it was 52 weeks ago. Rather, the market is simply willing to pay significantly less for equity in the trust.
In fact, commenting on recent separate sales of two hotels and a excess land parcel, CEO Jon Bortz noted: “All of these properties have been excellent investments for the Company, and the sale prices clearly demonstrate the disparity between private market values for our hotels and the value of our company as determined by the public market.”
So hotels are commanding strong prices and demand, yet the trust’s stock price appears to be disconnected from that dynamic.
The P/AFFO ratio sits at 9.73. That’s a single-digit ratio for a company growing well into the double digits. And then you have that really attractive yield that pays you in the meantime. Consider the five-year average yield is just 2.6%, or less than half of what it currently is. The dividend has grown quickly, but there’s still clearly a disconnect here.
I valued shares using a dividend discount model analysis. I assumed an 8% discount rate and a long-term dividend growth rate of just 4%. That growth rate is factoring in a massive long-term slowdown, which I think is really conservative so as to model in the unique risks and lack of a longstanding track record. With a dividend growth rate more than eight times that high since FY 2012, there’s definitely a margin of safety here. The DDM analysis gives me a fair value of $39.52.
Conclusion
I really like this company. I think the quality and location of their properties should provide for long-term competitive advantages. While the way people approach lodging is changing, I can’t imagine that people will ever stop wanting great rooms with great amenities and service in great cities.
The growth is astounding, the commitment to a big and growing dividend is apparent, and I believe there’s a disconnect between the stock’s value and its price. Indeed, the stock appears to be more than 50% undervalued right now.
This purchase adds $53.20 to my annual dividend income. I already owned 30 shares of PEB, so this transaction more than doubled my position.
I usually like to include valuation opinions from Morningstar and S&P Capital IQ so as to compare my perspective to that of some professional analysts, but neither firm tracks this stock.
I hope this article provided you readers some value. Keep in mind this was a real transaction with real money. My portfolio will be updated in early July to reflect this transaction.
— Jason Fieber
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