Bottom of the Barrel: Alexandria Could Build Up Healthy Returns

If you're looking for the building blocks of a small-cap, income-oriented portfolio, consider Alexandria Real Estate Equities (ARE Quote).

With a market cap of about $650 million, this real estate investment trust specializes in a healthy niche: providing the roofs under which life sciences companies innovate. From core pharmaceutical companies such as Pfizer (PFE Quote) to small, private cutting-edge biotech companies, Alexandria specializes in laboratory real estate.

That specialty provides solid returns. Since 1997, Alexandria has grown its funds from operations, or FFO, which is a REIT's measure of operating profits and cash flow, at a compounded annual rate of 18%. Even as the economy has slowed, Alexandria has remained healthy.

"Alexandria's life science niche remains one of the few pockets of strength in the real estate market," says Steve Sakwa, REIT analyst at Merrill Lynch. "Alexandria continues to see strong demand for its lab/office properties despite an expected weak economy for most of 2002." Sakwa rates Alexandria strong buy, and his firm has not provided banking services for the company.

Robust Research Fundamentals

Fueling Alexandria's continuing growth is robust research and development spending among life sciences companies. According to data from Goldman Sachs, pharmaceutical and biotech R&D spending increased 8.5% in 2001. Plus, the National Institutes of Health's budget will increase 15% in 2002, and President Bush's 2003 budget proposes another 16% increase next year.

With 92% of Alexandria's tenant base focused on research, that budget growth supports demand for space. Nearly 80% of Alexandria's tenant base is renewing leases as they expire.

At a Glance Alexandria Real Estate Equities (ARE:NYSE)
Current Price	$40.40
52-week Range	$41.93 - $35.54
Price-Earnings Ratio*	10.4
Market Cap	$652.1 million
Avg. Daily Volume	55,318
Inst. Ownership	90%
Dividend Yield	4.60%
Beta	0.0
Company Web Site	N/A
*Price/Funds from Operations (FFO) based on 2002 est. Source: Market Guide, Zacks, Company Reports

"We believe the tenant retention rate would be even higher if not for Alexandria's elective decisions," says Jim Kammert, REIT analyst at Goldman Sachs. "Management remains focused on upgrading its tenant base as it places assets into the redevelopment process or releases existing space." Alexandria is on Goldman's recommended list, and Goldman has provided banking services for the company.

The quality of its tenant base and its market niche insulate Alexandria from economic weakness. "Alexandria's tenant base is not only differentiated from other real estate owners and operators, but is also less vulnerable in the event of an economic downturn," says Kammert.

That doesn't suggest all smooth sailing for Alexandria. On the company's year-end earnings call last week, management said that leasing activity has slowed since Sept. 11 as many companies re-evaluate their expansion plans. However, the slowdown appears to have only a marginal effect on its redevelopment portfolio. In the fourth quarter, Alexandria's occupancy rate, excluding property under redevelopment, increased to 99%, up from 98.6% in the third quarter.

In 2002, leases on 10% of Alexandria's portfolio will expire, and the company expects to see rents increase by 10% to 15% on renewal. Alexandria will redevelop half of the space and has firm commitments on renewal for 75% of the remaining lease expirations.

Overdose?

The risks associated with Alexandria are its tenants. Many are unprofitable and depend on scientific funding and grants for sustenance. If scientific research funds contract, it would likely affect a broad spectrum of Alexandria's tenants, making re-leasing difficult. Similarly, Alexandria's portfolio is concentrated along research corridors and designed for its niche market, making leasing to nonresearch tenants impractical.

Fortunately, both public and private funding sources appear committed to continued funding for life sciences research. And Alexandria's discerning taste for tenants would ease the pain of any downturn. "Alexandria's thorough understanding of its tenant base and each company's revenue stream or long-term funding arrangements further enhances [its] defensive nature," says Kammert.

Also, with only 16 million shares outstanding, Alexandria could experience significant price volatility. Its relatively small portfolio -- just under 6 million square feet total -- means that every decision regarding redevelopment and vacancies can have a material impact on performance.

Finally, Alexandria has significantly higher capital expenditures than the typical office REIT. The costs associated with developing and updating scientific space are significant. To be profitable, the cost of updates has to be absorbed by future tenants. Should rent growth slow, Alexandria's margins would feel pressure.

Valuation

While Alexandria trades at a slight premium to other office REITs, the company's performance justifies that valuation. The stock currently trades at just above 10 times 2002 FFO estimates and about 9.5 times 2003 estimates, compared with 8.7 times 2002 and 8.2 times 2003 multiples for the average office REIT.

The Right Prescription Alexandria's steady growth pipeline
Year	Operating Revenue (in millions)	Funds from Operations per Share
1999	$86.3	$2.82
2000	106.9	3.17
2001	127.8	3.53
2002*	140.9	3.84
2003*	157.5	4.23
*Estimates Source: MarketGuide, Goldman Sachs, Company Reports, TSC Research

Moreover, just as most REITs are guiding expectations lower, Alexandria actually increased its 2002 FFO guidance and said it could continue 10% annual growth over the next several years.

Its balance sheet is clean -- sporting a debt-to-market-cap ratio of about 45% -- and it trades at a discount to its net asset value, which Kammert calculates at about $45 a share. It closed Friday at $40.40.

Add to that a 4.6% dividend yield, expected to grow by about 8% a year, and you have an attractive addition to the Bottom of the Barrel income portfolio.

Alexandria is a steady company with good prospects. While you can't expect 20% growth from a REIT, you can expect a safe dividend and stability. In this market, that's worth something. I give Alexandria three barrels.

For an explanation of our barrel rating system, see our recent description.

Arranging the Barrels

As the Bottom of the Barrel portfolio grows, many of you have asked for more frequent updates on its stocks.

You ask, I answer. The table below provides a new ratings update. In the future, the table will show both the original rating and my current outlook: positive, market or avoid. Very simple: I like the stocks that are on the positive list, think the stocks on the market list will follow the market and would avoid those on the avoid list. In addition, you'll occasionally see a stock labeled "special situation," which means the stock may react to a near-term news event. The table will also separate out the stocks in the Bottom of the Barrel "income portfolio."

Reviewing the Barrels Introducing the intermediate-term outlook for the Barrel Portfolio
Original Rating	Current Outlook	Company/Ticker	Date of Mention	Mention Price*	Current Price	% Change
Positive Outlook
	Positive	Netbank (NTBK:Nasdaq)	February 6, 2002	$13.45	$14.90	10.78%
	Positive	Endocare (ENDO:Nasdaq)	January 23, 2002	18.21	14.33	-21.31
	Positive	VitalWorks (VWKS:Nasdaq)	November 21, 2001	4.30	4.99	16.05
	Positive	FPIC Insurance (FPIC:Nasdaq)	November 14, 2001	12.83	14.20	10.68
	Positive	Witness Systems (WITS:Nasdaq)	October 31, 2001	8.06	12.18	51.12
	Positive	SurModics (SRDX:Nasdaq)	December 19, 2001	34.60	34.28	-0.92
Market Outlook
	Market	Coastal Bancorp (CBSA:Nasdaq)	December 12, 2001	27.84	30.44	9.34
	Market	Coinstar (CSTR:Nasdaq)	November 7, 2001	19.96	27.25	36.52
	Market	Hibbett Sports (HIBB:Nasdaq)	October 24, 2001	30.33	31.80	4.85
	Market	Quixote (QUIX:Nasdaq)	October 3, 2001	21.44	18.01	-16.00
Special Situations
	Special Sit.	Quanta Systems (PWR:NYSE)	January 9, 2002	16.05	13.50	-15.89
Avoid Outlook
	Avoid	Actrade (ACRT:NYSE)	January 30, 2002	$20.65	$16.93	-18.01
	Avoid	Goody's Family Clothing (GDYS:Nasdaq)	November 28, 2001	4.50	4.05	-10.00
	Avoid	Bridgford Foods (BRID:Nasdaq)	October 10, 2001	13.18	11.00	-16.54
Income Portfolio
	Yield
	6.04	Empire District Electric (EDE:NYSE)	January 16, 2002	21.23	21.20	-0.14
	2.43	Met-Pro (MPR:NYSE)	October 17, 2001	11.16	14.07	26.08
	4.62	Integra Bancorp (IBNK:Nasdaq)	January 2, 2002	20.75	20.35	-1.93
*Average price on date of mention. Source: TSC Research

A couple of specifics this week: Actrade (ACRT Quote) took a hit Monday after Barron's raised questions about the its business and the sordid history of those in the executive suite. I've scoured sources and talked to a number of investors both short and long Actrade, but there's simply too much unknown and, potentially, undisclosed here. Although the stock saw a nice rebound Tuesday, the uncertainties are troubling and would keep me away from the stock.

Finally, Quanta (PWR Quote) announces earnings early Thursday. Although I'm interested in its outlook for telecom demand into 2002, I'm more interested in its comments about its relationship with UtiliCorp (UCU Quote), which may wage a proxy battle to replace the board with UtiliCorp sympathizers. Looks like a precursor to a potential UtiliCorp bid for the company, which I think would be in the $16.50 to $18 range. Quanta is now a "special situation" stock in the portfolio.

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Do you have candidates for Bottom of the Barrel? If so, shoot me an email with the company's name, why you think it qualifies and your full name and hometown. If I profile your suggestion, I'll send you a TSC gift to commemorate your pick.