I have been browsing the market for the last two weeks in search of a stock to short when I came across Realty Income Corp (ticker “O”) on Distressed Debt Investing.com, one of my favorite blogs, where the author reported some notes from the “Best Ideas Symposium” on October 11 in Dallas. The Company was presented as a short play and it seemed like an interesting idea, so I did my due diligence and here is what I have found.
Business Model The Company’s primary objective is to generate a dependable monthly dividend to shareholders supported by cash flow income from a portfolio of properties leased to regional and national retail chains. The firm doesn’t really have any other type of operation, their only source of revenue is rent and it’s highly dependable on the lessees’ capacity to pay.
Free Cash Flows The firm generates all the operating cash flow from rental income and it’s all used to pay dividends to common and preferred shareholders and obligations. Note that FCFE is cash available before common shareholders are paid.
| FCFE | Common Dividend | |
| 2003 | 79,752m | 83,842m |
| 2004 | 94,724m | 97,420m |
| 2005 | 172,138 | 108,575m |
| 2006 | 74,526m | 129,667m |
| 2007 | 340,187m | 157,659m |
| 2008 | 23,369m | 169,659m |
Table 1
The dividend has been raised every year since 1994 and has now reached a level where the amount is more then what the company can pay with cash on hand. In fact, in 2003 the Company started to explore other ways to raise capital such as issuing equity and debt. There is nothing wrong with raising funds though offerings but if you don’t reinvest the proceeds at a higher rate, eventually you will be forced to rollover debt continuously, and then burn all of your cash.
Capital Structure The capital structure changed dramatically in 2003, when the company started to issue unsecured notes to finance its dividend payments, and that’s when solvency and liquidity ratios deteriorated, we will look at that later.
| Notes Outstanding | Issue Date | Maturity Date | Amount |
| 8% Senior Unsecured | Jan 1999 | Jan 2009 | 20 mm |
| 5.375% Senior Unsecured | Mar 2003 | Mar 2013 | 100 mm |
| 5.5% Senior Unsecured | Nov 2003 | Nov 2015 | 150 mm |
| 5.875% Bond | Mar 2005 | Mar 2035 | 100 mm |
| 5.375% Senior Unsecured | Sept 2005 | Sept 2017 | 175 mm |
| 5.95% Senior Unsecured | Sep 2006 | Nov 2016 | 275 mm |
| 6.75% Senior Unsecured | Sept 2007 | Sept 2019 | 550 mm |
| 1,370 mm |
Table 2
In September 2008, the company issued shares of common stock (at a price of $26, which is almost record high, an indication of the stock being overvalued) and used the proceeds, about 75mm, to repay of 120mm in notes outstanding at par.
| Issuance | Date | Amount |
| Common Stock | Sept 2005 | 93 mm |
| Common Stock at $24.39 | Mar 2006 | 120 mm |
| Common Stock at $24.32 | Sept 2006 | 109 mm |
| Common Stock at $26.40 | Oct and Nov 2006 | 173 mm |
| Preferred Stock at $25 | Dec 2006 | 214 mm |
Table 3
Covenants On the 2008 10K report, the Company reported to be “in compliance” with the bond covenants for the Senior Unsecured Notes outstanding, but after a closer look, it doesn’t seem the case. The issue lies with the way assets are recorded. Land and commercial properties are reported at book value, which can be significantly different then fair value, especially in a real estate downturn. If assets are reduced by 15% to 20%, the debt to asset ratio would rise to 65%, which is above 60% limit imposed by the bond covenants.
Liquidity Cash levels are on average 1% or less of total assets, which is very low and that raises some liquidity concerns. Also the current ratio, except for 2007, has been historically around 0.7 or less and this doesn’t account the 355 mm credit facility originated in 2008 which has no outstanding balance now, but if used could significantly increase short-term liabilities and further deteriorate liquidity.
Lessees I wasn’t able to find any information about the lessees but few names are identifiable if you read the 10K report or the Company website. There is Office Max, rated “B” at S&P, Wawa Convenience Store, Jiffy Lube, basically unknown local stores, it’s a joke! Because all of the firm’s revenue is generated from lease payments, it’s important to know who the lessees are and the capacity to meet their obligations. Poor financial performances of a lessee, solvency issues or failure to make payments on time, could result in material losses. For example, on January 22, 2008, Buffets Holdings Inc filed for reorganization under Chapter 11 of the U.S. Bankruptcy Code and Realty Income owned 116 properties.
Conclusion The Company will have to cut the dividend of $1.71/share because it doesn’t have cash on hand to pay for it and is using proceeds from stock or debt offerings. The Company might be forced to sell assets at a loss to generate cash but that would deteriorate debt to asset ratios, which could cause a default on the terms of the debt covenants set in the indenture. The names and financial conditions of the lessees are a key ingredient to firm’s profitability but are a big unknown. This seems to be easy money, I don’t see the stock going higher, but there is one downside: when you are short, you PAY the dividend, a big one in this case. Target price $12 within 6 months. I will provide discount cash flow analysis in future posts. Have a good day.