Continued Demand for Logistics Should Drive Growth for Prologis for Several Years
Continued Demand for Logistics Should Drive Growth for Prologis for Several Years
Business Strategy and Outlook| by Kevin BrownUpdated Mar 23, 2022
Prologis leases distribution space to some of the nation’s top retailers, and we think its tenant list is the strongest in the business. The continued growth in e-commerce should provide a long growth runway for distribution and logistics facilities, especially given the large amount of space necessary to support online sales compared with brick-and-mortar retail. We find it is difficult for industrial REITs to earn moats since supply can quickly and easily enter key cities to negate supply and demand imbalances. The aggressive construction after the financial crisis brought significant new facilities on line, and we expect supply to continue to grow. Although demand outpaced newly added supply for several years, supply additions have increased sharply, and we are cautious that a slowdown in consumer spending could expose the asset class, increasing vacancies, as seen in the recent downturn.
With vacancy rates hovering around historic lows in the United States and Europe and average market rent rebounding significantly since 2012, we believe Prologis is in the best position to benefit from incremental demand. The company's vast portfolio surpasses all other logistics REITs in size, predominantly along coastal markets, where it more than doubles its competition. There is an undeniable shift toward tech-savvy millennial consumers, who are more likely to skip the brick-and-mortar locations and spend more time on retail websites and utilize mobile purchasing. They are also more likely to return items, which adds to the space needed to fuel the growing e-commerce distribution industry. As retailers seek additional distribution facilities closer to population centers to accommodate this trend, Prologis will tap into its deep land bank to complete lucrative developments and drive value for shareholders.
Economic Moat| by Kevin BrownUpdated Mar 23, 2022
We assign a no-moat rating to Prologis. The primary moat source for REITs is efficient scale, where the firm operates in a market of limited size that is effectively and efficiently served by one firm or a small number of firms. Despite Prologis’ significant global presence, the industry is fragmented and littered with competitors, and we do not see any indicators of competitive advantages for the company. To focus on its core market, we look to its operation in the U.S. The industrial real estate segment represents over 80% of revenue, while 93% of this segment stems from operations in the U.S. The company’s presence in Asia and Europe is reflected in its strategic capital segment, where Prologis provides asset and property management services. We do not view this segment as moaty since it’s more closely aligned with strategic investing rather providing an avenue for operational advantages. Additionally, the company faces high competition from overseas investment managers for institutional capital.
The U.S. contains over 9.7 billion square feet of warehouse and distribution space, and of that space, Prologis accounts for around 460 million square feet, or 4.8%. Although demand for space is increasing rapidly, so is the newly developed construction coming to market every year. In 2019, new developments exceeded 260 million square feet, the highest level in over a decade. While vacancies are hovering around historically low levels, the response from increased construction over the past several years has supported our view that any increase in demand for industrial warehouse and distribution space can be appropriately met with new supply.
We view Prologis’ facilities as among the best in terms of quality and location, with a concentrated presence that closely aligns with regions representing the lowest capitalization rates in the country, such as Chicago, Miami, Dallas, Seattle, and coastal California. However, while Prologis’ facilities may be newer and well located, nothing in them is difficult for competitors to replicate. We expect future new developments to remain concentrated in key warehouse locations across the country, especially on the outskirts of densely populated cities. With a significant percentage of new construction estimated to be speculative, it appears banks and companies are willing to finance projects without any tenant commitment before breaking ground.
While location plays a key role in the strength of a portfolio, the massive size of most facilities is such that they are typically located near densely populated areas instead of in them. This makes it difficult for any warehouse to differentiate itself because of the abundance of unutilized or underutilized land surrounding large population centers. Additionally, distribution warehouses are a highly commoditized real estate asset class to develop, supporting our view that any outsiders with financing can enter the market and participate in new construction whenever demand outpaces supply. We traditionally view the ability to effectively rebalance short-term differences in supply and demand as supportive of a no-moat rating in the REIT sector.
Industrial real estate tenants typically sign leases that are three to five years long on average, which does not support a switching-cost moat source. The short length of stay is further complicated by the commoditization of these facilities and the numerous substitutes available in key metropolitan distribution hubs. With vacancy rates hovering at historically low rates, landlords continue to push rents, fueling the industry’s growth. With the significant growth in supply, we expect this growth to return to midcycle conditions over the next five to 10 years. Indeed, Prologis itself maintains an active development pipeline, with a significant portion of its developments located in the U.S.
We attempt to approximate Prologis’ economic returns through analyzing its adjusted returns on invested capital. We accomplish this by adjusting our traditional ROIC calculation to include only an estimate of economic depreciation, which we approximate as annual operations capital expenditures, instead of accounting depreciation. By these steps, we calculate that Prologis has earned an adjusted ROIC below its 8.5% weighted average cost of capital in recent years. While the firm’s historical results might be obscured by a significant level of development activity, we expect adjusted ROIC to fall short of WACC over the next 10 years.
Fair Value and Profit Drivers| by Kevin BrownUpdated Mar 23, 2022
We are increasing our fair value estimate to $143 per share from $131 after updating for the company's fourth-quarter results and making adjustments to our revenue growth assumptions. Our fair value estimate implies a 36 times adjusted EBITDA multiple. Our weighted average cost of capital for the company is 7.2%.
In our base case, we assume revenue grows quickly in the near term, due to a buoyant market and recent acquisitions, and slows gradually in later years. We anticipate that developments will yield approximately 7%. Worries about disruptions in trade agreements have surrounded Prologis, but management considers this a tailwind in the current business environment with most of the company’s activity coming from the U.S.
Prologis' portfolio carries some of the lowest cap rates near the most in-demand cities in the country. From a macro perspective, e-commerce should continue to drive the amount of distribution space needed. Retailers require 3 times the amount of distribution space for e-commerce sales compared with brick-and-mortar sales. Specifically, for every additional $1 billion in online sales, retailers need an additional 1 million square feet of distribution space. Additionally, net absorption has been strong in recent years, so we view the combination of these factors as enough to counter any increases in supply hitting the market in the near term.
Our estimates reflect that net operating income should grow in the midsingle digits for the explicit forecast period. Growth since the recession is beginning to moderate, and we think mid-single-digit growth reflects strong demand for warehousing space.
Risk and Uncertainty| by Kevin BrownUpdated Mar 23, 2022
Consistent with our moat outlook for logistics and distribution facilities, we view additional supply as the greatest threat to Prologis. Low barriers to entry should allow a significant increase in new construction to continue, from recent lows of about 25 million square feet in 2010 to over 260 million square feet currently. The quick response from developers to capitalize on excess demand gives us hesitation about Prologis’ growth prospects in a fiercely competitive industry. Our concerns include Prologis’ ability to secure and maintain tenants as well as its ability to increase rents, both of which are difficult in such a fragmented industry in which the end product is relatively commoditized.
On the demand side, macroeconomic conditions affecting global trade is our primary concern. The new administration has exhibited a desire to rearrange some key trade agreements that could affect domestic relationships with important trade partners, particularly Mexico and China. Management did acknowledge that severe trade restrictions would negatively affect not only Prologis but the economy in general, resulting in a slowdown in growth. With Prologis’ large presence in 20 countries, we think that over the long run, the company exhibits more sensitivity to international political tensions than some of its domestic competitors.
The rise in e-commerce should continue to drive demand for warehouse space, although vertical integration among some of Prologis’ largest customers is a concern. Notable investments in distribution and logistics have been made by the likes of Amazon and FedEx, so tenants taking distribution efforts in-house could result in higher vacancies industrywide.
The company may face environmental, social, and governance risks that would negatively affect the portfolio or cash flows. These include properly maintaining the safety of the buildings across the portfolio, paying a competitive wage to employees, and accounting for the future impact of climate change.
Capital Allocation| by Kevin BrownUpdated Mar 23, 2022
We give Prologis a Standard capital allocation rating. In our opinion, the company’s balance sheet is sound, its capital investment decisions are fair, and its capital return strategy is appropriate. We view Prologis' balance sheet as sound as the company operates at a reasonable level of leverage for the REIT industry. We project 2022 net debt/EBITDA to be roughly 6.0 times, which is within the company's long-term target and in line with our view of an appropriate level for a REIT. The company’s capital investment decisions are fair, with Prologis predominantly growing through a mixture of internal growth, development, and acquisitions. Typically growth through acquisition yields little accretive growth to shareholders, though the company generally completes a far greater volume of development projects that create more risk but also produce higher yields. We assess the company’s capital return strategy as appropriate. Prologis has averaged a dividend payout ratio of 75% of adjusted funds from operation over the past several years, which we think is an appropriate level for a REIT, and we believe that it will continue to increase the dividend over the next few years to maintain this level of payout.
Management has created significant shareholder value while expanding the reach of the firm and capitalizing on e-commerce tailwinds. Over the past several years, the company became more efficient with its land bank, reducing it to $1.3 billion from about $2 billion at the time of the merger with AMB. The company’s land recycling has lent itself to lucrative developments over the past several years. Management believes that it has the potential to develop significant new development projects as a mechanism for boosting shareholder value.
Chair and CEO Hamid Moghadam co-founded AMB Property in 1983 and led it through the 2011 merger with ProLogis to form the current version of the company. Almost all Moghadam’s leadership team has over 10 years’ experience with the company and has legacy roots before the merger. The current team has created much value for shareholders after the merger and managed turbulent times during the financial crisis. Prologis has substantially increased funds from operations over the past business cycle, exemplifying management’s resilience after a tough time in real estate.
Overall, Prologis’ strategy should make it a dominant player in the industry for the long term. The company already has a substantial lead in terms of number of facilities and land bank compared with its competition. It has trimmed its land position during a time of high prices and has become more efficient with its balance sheet, which could allow it to slightly consolidate the fragmented market.