NOT AN ANALYST

For all the loyal readers out there, this is why it pays off reading this Blog. One of my earliest posts was about a value opportunity that was hiding behind a technicality on certain Citigroup non-cum equity preferred shares (CprP, CprM and CprI). Here is a link to my post in case you don’t remember:

http://www.notananalyst.com/2009/10/17/citigroup-preferred-shares/

Background In February 2009, Citigroup announced the suspension of dividends on certain non-cum equity preferred (CprP, CprM and CprI) as the securities were converted into equity in an effort to raise tangible common equity and capital requirements. In theory, preferred shares that don’t pay a dividend are worthless based on the Gordon Growth Model but those preferred continued to trade despite the suspension of the dividend due to a technicality. That’s when the value opportunity became evident.

Technicality As I described in my original post, holders of the non-cum equity preferred shares were required to vote on a series of amendments and the most important among them was the dividend blocker. That amendment was designed to eliminate the legal obligation of the issuer or Citigroup to pay dividends on the non-cum equity preferred even if some investors elected not to exchange their shares. However, the dividend blocker didn’t pass and Citigroup became legally obligated to pay a dividend on the outstanding non-cum equity preferred shares before it could pay a dividend on common shares. As a result, the equity preferreds that were trading ex-dividend continued to rise, on speculation of a possible dividend payment in the future.

IRR In my original post, I proposed a scenario in which Citigroup would defer the dividend for six quarters and resume it afterwards. Now, after only four quarters, Citigroup has announced the reinstatement of the non-cum equity preferred dividend. The trade idea yielded an IRR of about 49.5% for each security, significantly higher that the 20% IRR I expected.  Here is the press release:

NEW YORK – The Board of Directors of Citigroup (NYSE:C) today declared dividends on preferred stock as follows:

6.5% Non-Cumulative Convertible Preferred Stock, Series T, payable November 15, 2010, to holders of record on November 5, 2010. Holders of depositary receipts, each representing one-thousandth of a full convertible preferred share, will be paid $.8125 for each receipt held.

8.125% Non-Cumulative Preferred Stock, Series AA, payable November 15, 2010, to holders of record on November 5, 2010. Holders of depositary receipts, each representing one-thousandth of a full preferred share, will be paid $.5078125 for each receipt held.

8.40% Fixed Rate / Floating Rate Non-Cumulative Preferred Stock, Series E, payable November 1, 2010, to holders of record on October 20, 2010. Holders of depositary receipts, each representing one-twenty-fifth of a full preferred share, will be paid $42.00 for each receipt held.

8.50% Non-Cumulative Preferred Stock, Series F, payable December 15, 2010, to holders of record on December 3, 2010. Holders of depositary receipts, each representing one-thousandth of a full preferred share, will be paid $.53125 for each receipt held.

On February 27, 2009, at the time of the announcement of its public and private exchange offers, Citi announced the suspension of dividends on its Preferred Stock. Pursuant to the exchange offers, Citi offered to exchange up to $14,923,650,000 of its outstanding publicly-held Preferred Securities for Common Stock at a price per share of $3.25; 98% of the Preferred Stock elected to participate in the exchange offers. Dividends declared today will be paid on the Series AA, T, E and F Preferred Stock that remains outstanding.

Common Dividend The dividend reinstatement on those outstanding non-cum equity preferred is a hint to investors. Citigroup should be in no rush to reinstate the dividend on the non-cum equity preferred unless the Company is getting ready to repay a common dividend.  In my opinion, Citigroup will announce the payment of a $0.05 quarterly common dividend in the 1Q of 2011. Stay tuned.

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.

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.

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.

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.