NOT AN ANALYST

The attachment below explains the reasons why Pershing Square is shorting Realty Income Corp. I don’t really agree that, with a 7.50% drop in NOI and a Cap Rate of 9.50%, the price should be 14 dollar per share. The company is currently valued with a very conservative Cap Rate, around 11%, which accounts for all the risks and unknowns. In my previous post, I wrote that 26 dollar per share is a fair price for the Company at this moment. I don’t see 40% premium to NAV as Pershing Square indicates. It’s also interesting how, during the Q1 and Q2 earnings call Q&A, the Company Representative wouldn’t even talk about the name of the tenants. I agree with the fact that the SEC may require to disclose the name of the lessees, which is another catalyst for a large drop in value. Well, enjoy the reading.

The Catalyst About a month ago we talked about Realty Income Corp as a good candidate for a short play, but since then the stock hasn’t really move in any direction. Let’s take a closer look at what can be the catalyst for a significant drop in value. The latest 10K reports that there are no maturities due until March 2013; therefore the company doesn’t need to refinance its debt anytime soon. But if the company wants to sustain or raise the common dividend, it would need to issue equity or new notes as the cash on hands and the operating income generated is not sufficient. I seriously doubt the company could raise funds early next year, so the only option would be to cut the dividend dramatically, which would cause a significant drop in price.

Tough Short It’s inevitable that the company will cut the common dividend, the problem is when. Keeping a short position open on Reality Income Corp it’s very expensive. You have to pay the big dividend to the long and it is an expensive stock to borrow because the amount of shares short as a percentage of the float is pretty high, around 22%.

NOI and Price There is no misprice at the moment between the intrinsic value and the market value. If NOI for next year is projected to drop 20%-25% from 2009 levels, the company should be valued around 19 dollars per share, but accounting for 303 mm in NOI for 2009, which seems accurate based on the latest 10Q, the company it’s correctly priced at 26 dollars per share. We calculate the Market Value as NOI/Cap Rate and the share price as the MV/shares outstanding. The cap rate is r (required rate of return) – g (growth rate). The required rate of return is simply the WACC = wd*D (1-T) + we*E. The capital structure consists of 47% debt and 53% equity. The yield on the latest bond issued, which is the 6.75% note issued on September 2007, is 6.50%. The tax rate is minimal as REITs are exempt from federal income tax, so I am going to ignore it. The yield on the common shares is now 6.54%. This gives us a WACC of 6.52%. The growth rate is calculated as the retention rate (b)*ROE. Net Income available to common shareholders for 2009 will be around 105 mm with cash dividends for the year amounting to 178 mm, which give us a retention rate (b) of -69%. ROE for 2009 is going to be around 6.7% and we arrive at a negative growth rate of 4.6%. Therefore the cap rate, calculated as r-g, it is 11.12%. Now we have all the data, with 104 mm shares outstanding and assuming NOI for 2009 remains at 303 mm, the Company is valued at 2,725 mm and the price per share is 26.2, which is around what it’s currently trading. However, if NOI drops 20% or 25%, which is a possible scenario accounting for the poor quality of lessees and their questionable capacity to pay, then the share price should be at least 6-7 dollars lower.

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.