Description

(Note:  The shares outstanding in the box above include OP units; net debt and TEV include preferred stock.)

American Capital Realty Properties, Inc. (ARCP) trades at a significant discount to its closest peers, with near term catalysts that should cause a re-rating of the stock and a closure of the discount.

ARCP common stock has been the subject of two previous VIC writeups, in 2013 and 2014 (the Series F preferred was the subject of a separate writeup in 2014).  The thesis then (similar to today) was that ARCP traded at an unwarranted discount to its closest peers.  The writeups (especially the 2013 writeup) generated large comment threads, with some members arguing forcefully that the discount was warranted.  They were correct - in fact, the discount wasn’t big enough.  However, much has changed since then.

Company.  ARCP is a self-managed real estate investment trust which operates through two business segments:  (1) the real estate investment segment, in which ARCP acquires, owns, and operates real estate consisting primarily of single-tenant, freestanding, commercial real estate properties subject to long-term triple net leases; and (2) Cole Capital, a private capital management business which sponsors and manages non-traded REITS.  Events during the past year have significantly impaired the Cole Capital business; accordingly, the real estate investment segment will be the primary focus of this writeup.

Background.  ARCP was incorporated in 2010 and completed a $70 million IPO in September 2011 at $12.50 per share.  ARCP was sponsored by Nicholas Schorsch, a large player in the non-traded REIT space and a full-fledged empire-builder.  The company grew quickly, primarily through M&A, expanding from an enterprise value of approximately $150 million at the end of 2011 to a current enterprise value of over $18 billion.  Major transactions included:

• 2012 - Merger with American Realty Capital Trust III Inc., a Schorsch sponsored non-traded REIT (over $2 billion).
• 2013 - Portfolio acquisition from GE Capital ($774 million).
• 2013 - Merger with (acquisition of) CapLease Inc., an unaffiliated NYSE-traded REIT (over $2 billion).
• 2013-2014 - Portfolio acquisition from Fortress Investment Group LLC ($600 million).
• 2014 - Merger with American Realty Capital Trust IV, Inc., another Schorsch sponsored non-traded REIT ($3 billion).
• 2014 - Merger with (acquisition of) Cole Real Estate Investments, Inc. (over $11 billion).  With this transaction, ARCP acquired both a large portfolio of net lease real estate and the Cole Capital private capital management business.
• 2014 - Red Lobster portfolio acquisition ($1.7 billion).  In connection with Golden Gate Capital's purchase of the Red Lobster chain from Darden Restaurants, ARCP acquired 544 properties (522 of which were Red Lobster properties).  The transaction was structured as a sale-leaseback in which ARCP purchased the portfolio and immediately leased the portfolio back to the seller pursuant to multiple master leases.

Accounting Restatement.  The combination of pell-mell growth and a promotional management team yielded an unsurprising result:  In October 2014, ARCP reported that the financial statements contained in its 2013 10-K and its Forms 10-Q for the first and second quarters of 2014 should no longer be relied upon.  Subsequently, the filing of ARCP's 10-Q for the 2014 third quarter was delayed.

An investigation followed, conducted with the assistance of Weil, Gotshal & Manges and Ernst & Young.  The investigation and restatement were completed on March 2, 2015, on which date ARCP filed amendments to its 2013 Form 10-K and its first and second quarter 2014 Form 10-Qs, as well as its delayed Form 10-Q for the third quarter of 2014.  ARCP subsequently filed its 2014 Form 10-K on March 31, 2015 and its first quarter 2015 Form 10-Q on May 7, 2015, and is now on a normal reporting schedule.

The investigation did not identify any material changes relating to ARCP’s real estate ownership, rental revenue, or business operations.  The accounting restatements that were identified were relatively minor:

• Net loss was slightly understated for 2013 (including each quarter of 2013) and the second quarter of 2014; net loss was slightly overstated for the first quarter of 2014; and adjusted FFO was slightly overstated for 2011, 2012, 2013, and the first two quarters of 2014.

• The investigation identified certain payments made to Schorsch-affiliated entities that were not sufficiently documented, and ARCP recovered approximately $8.5 million in respect of certain such payments that the investigation concluded were inappropriate.

• The investigation found that equity awards made to Schorsch and ARCP's former CFO contained provisions that, as drafted, were more favorable to such executives than the compensation committee had approved.  With one exception, these equity awards were relinquished by Schorsch and the CFO, and the retained award is subject to a clawback.

Of greater importance, the investigation found material weaknesses in ARCP's internal controls over financial reporting and its disclosure controls and procedures.  While implementation of a remediation plan has commenced, as of ARCP's first quarter 2015 Form 10-Q, these weaknesses had not been fully remediated.

While the accounting effects of the restatement were (with the exception of the internal control deficiencies) relatively minor, the business consequences were substantial.  These included a significant impairment of the Cole Capital business, government investigations and investor litigation, credit rating downgrades and a suspension of the dividend, and (on a positive note) a complete reconstituting of senior management and the board of directors.  In addition, the share price collapse resulting from the restatement and investigation prompted an investment, beginning in December 2014, by activist investor Corvex Management, which now holds a 7.8% stake in ARCP.

Affect of Restatement on Cole Capital.  The investigation did not identify any changes to the financial statements or operations of the Cole Capital-sponsored non-traded REITs.  Nonetheless, the restatement and related investigation had a material negative effect on the Cole Capital business, significantly impairing its value.  In response to the restatement, most broker dealers and clearing firms who did business with Cole Capital suspended their selling agreements with Cole.  This had a deleterious effect on fundraising - capital raised (not including dividend reinvestment) fell from $132 million in 4Q 2014 (most of which was raised in October) to $30 million in 1Q 2015.

After the restatement was completed, Pershing, Fidelity, TD Ameritrade, and Schwab resumed clearing trades of Cole-sponsored products, and many broker dealers lifted their suspension.  According to management, 201 broker dealers and investment advisors are now able to sell Cole Capital-sponsored REITs.  However, fundraising remains tepid, and management has a long road ahead to restore confidence.  For 2015, Cole Capital will likely simply break even.

Regulatory Investigations and Litigation.  The SEC notified ARCP that it commenced a formal investigation and issued subpoenas calling for the production of documents.  In addition, the United States Attorney’s Office for the Southern District of New York contacted counsel for the audit committee and ARCP with respect to the accounting restatement and investigation, and the Commonwealth of Massachusetts issued a subpoena calling for the production of various documents.

ARCP and certain current and former directors and officers have been named as defendants in a number of lawsuits filed in response to the accounting restatement and investigation, including class actions, derivative actions, and individual actions under the federal securities laws and state common and corporate laws in both federal and state courts in New York and Maryland.  ARCP has not established a reserve for this litigation.

Given that the investigation did not identify any material changes relating to ARCP’s real estate ownership or rental revenue, and given that the accounting restatements were relatively minor, it seems unlikely that the investigations and litigation will result in significant financial consequences.  However, the regulatory investigations and the litigation will be a drain on management time, and will result in elevated legal expenses until the matters are resolved.

Credit Downgrade; Lender Covenants; Suspension of Dividend.  Prior to ARCP's disclosure of accounting irregularities, ARCP was an investment grade credit.  In December 2014, Moody's and S&P downgraded ARCP to junk status.

In December 2014, ARCP obtained extensions from its credit facility lenders for the delivery of its third quarter 2014 financial statements and its full year 2014 audited financial statements.  ARCP obtained similar extensions from its unsecured note holders in January 2015.  ARCP complied with the terms of the agreed extensions and is now in good standing with its lenders and noteholders.

As part of the December 2014 extension agreement with the credit facility lenders, ARCP agreed to permanently reduce its credit facility to $3.6 billion.  At that time, ARCP also agreed to suspend the dividend on its common stock until it delivered its 2013 financial statements, 2014 financial statements, and related compliance certificates.  All required financial statements and certificates have been delivered, and ARCP may permissibly reinstate its dividend (the going forward dividend policy is discussed later in this writeup).

Management and Board Changes.  In December 2014, Nicholas Schorsch resigned his position as executive chairman.  In addition, in the fourth quarter of 2014, ARCP's chief executive officer, chief financial officer, chief operating officer, and chief accounting officer all resigned their positions.

Glenn Rufrano was appointed ARCP's chief executive officer and a director, effective April 1, 2015.  Also effective April 1, 2015, two legacy Schorsch directors resigned, and Hugh Frater was appointed non-executive chairman of the board and Julie Richardson was appointed an independent director.  Effective June 17, 2015, Mark Ordan was appointed an independent director.  The board now consists of Frater, Rufrano, Richardson, Ordan, Bruce Frank, William Stanley, and Thomas Andruskevich.  Four of the seven directors were appointed in 2015, and Frank was appointed in 2014.  Four of the directors (Frater, Rufrano, Ordan, and Frank) have extensive real estate experience, and one director (Richardson) has extensive private equity and capital markets experience.  Only two directors with historic ties to Schorsch entities remain (Stanley and Andruskevich); their status will be reconsidered at the annual meeting which should occur no later than October 2015.

Rufrano was the chief executive officer of New Plan Excel Realty Trust, a commercial retail REIT, from 2000 to 2007, when it was acquired by Centro Properties Group, an Australian shopping center company.  In 2007, Rufrano was appointed chief executive officer of Centro Properties Group U.S., and became the chief executive of Centro Properties Group in 2008, serving until 2010.  Rufrano was the chief executive officer of Cushman & Wakefield, Inc. from 2010 to 2013.

Frater was a founding partner and managing director of BlackRock, Inc., serving there from 1988 until 2004.  From 2004 to 2007, Frater was an executive vice president at PNC Financial Services, where he led the real estate division.   From 2010 to 2014, Frater was the chief executive officer of Berkadia, a commercial real estate company jointly owned by Berkshire Hathaway and Leucadia National Corporation, and since April 2014, he has served as Berkadia's chairman.

Corvex Investment.  In December 2014, Corvex Management (Keith Meister) filed a Form 13D, giving notice that it had acquired a 7.1% stake in ARCP.  Corvex subsequently upped its stake to a 7.8%.  Interim management (William Stanley, a Schorsch holdover, served as interim CEO from December 2014 until Rufrano took over in April 2015) did not engage constructively with Corvex, rebuffing Meister's requests to be added to the board and to participate in the search for a permanent CEO and chairman.  Corvex made its displeasure known.  However, since April 1 (when Rufrano became CEO and Frater was appointed chairman), Corvex has maintained radio silence.  Based on management commentary, I believe new management has engaged in a more constructive manner with Corvex (they would be foolish not to).

Corvex's involvement is clearly a positive.  Corvex's actions (with others) greatly improved the future prospects of CommonWealth REIT, now known as Equity Commonwealth.  Corvex's presence should deter (to the extent deterrence is necessary) the new management team from engaging in unnecessarily dilutive transactions while restoring ARCP to normalcy.

Valuation and Comps.  My estimate of 2015 EBITDA, adjusted funds from operations, fee cash flow, and cash net operating income is below.  The estimates include no contribution from Cole Capital, and all metrics are computed ascribing no value to Cole.  Dollars are in 1,000's.

ARCP's closest peers are Realty Income (O) and National Retail Properties (NNN).  Agree Realty and Spirit Realty are excluded from the comparison.  Agree is a small cap company ($500 million), and still has significant geographic concentration (28% Michigan).  Spirit Realty is more highly leveraged than O and NNN (though not as leveraged as ARCP), and has lower quality tenants, focusing on mid-market tenants rather than national investment grade tenants.  While both trade at a discount to NNN and O (but more richly than ARCP), neither has the catalysts available to ARCP to close the discount.

As the following table shows, ARCP trades at a significant discount to O and NNN.

Both O and NNN trade in excess of 16x adjusted FFO.  Valuing ARCP at a less generous 15x yields a stock price over $12, more than 40% higher than the current price.

Business Plan.  ARCP plans to present a business plan during its second quarter earnings call in early August.  According to management, the plan will include (1) an analysis and review of ARCP's properties, (2) the strategy for Cole Capital, (3) direction on how ARCP plans to manage its balance sheet, with a view to regaining investment grade ratings, and (4) based on the results of the foregoing, the establishment of a dividend policy.

Culling Properties.  At REIT Week in June, Rufrano stated that ARCP would be a net seller of assets in 2015 and will likely not make any further acquisitions through the balance of the year.  On the first quarter call, Rufrano stated that the property review would likely result in the culling of properties.  He specifically discussed the Red Lobster properties, suggesting that their share of the total portfolio (11%) will be reduced over time to create proper diversification.

Importantly, however, Rufrano has acknowledged that ARCP does not need to do anything, and has stated that "There will be no fire sale anywhere at ARCP."  Thus, assuming proper execution, the culling of the portfolio will be done in a way that retains value.

Cole Capital.  Rufrano has said that he views Cole Capital as an asset to ARCP, and that ARCP will do what is necessary to bring Cole back to the "brand value that it had" prior to the accounting restatements.  In that regard, in June, ARCP named William Miller as chief executive officer of Cole Capital, to lead the turnaround effort.  Miller was previously a senior vice president with American Funds where he was responsible for leading business development, strategy, and relationship management efforts for broker-dealers.

However, in addition to the issues caused by the accounting restatement, the Cole business faces secular challenges.  The non-traded REIT sector has been subject to increased regulatory scrutiny, with new disclosure rules from FINRA becoming effective in 2016.  More to the point, the business is unsavory, with an army of brokers peddling illiquid real estate investments with usurious fees to retail investors, with the promise of "low volatility."  Even if the Cole business was restored fully to its pre-restatement performance, it would at best constitute 10% of ARCP's EBITDA, a small contribution requiring inordinate management attention.  In an ideal world, management would rehab the Cole business the best that it could, and sell it.  In any event, I am attributing no value to the Cole business.

Deleveraging.  Prior to its current travails, the reason frequently given for why ARCP traded at a discount to its peers on an FFO multiple basis was that it was more highly leveraged than its peers.  The criticism had two components:  (1) that ARCP was simply too highly leveraged and (2) that ARCP relied imprudently on shorter-term debt, which reduced its interest rate and thereby juiced its FFO.

The first criticism has limited merit in my view.  Triple net lease REITs can operate comfortably with higher leverage - just because O and NNN operate with lower leverage does not mean that lower leverage is optimal.  However, management has stated that it is aware of its competitors' credit metrics and desires that ARCP be restored to investment grade.  Thus, leverage will almost certainly be reduced over time.

The second criticism is fully justified.  ARCP did imprudently rely on shorter term financing - a classic case of funding long term investments with short term debt.  I expect that ARCP's debt will be termed out over time, which will ultimately increase the effective interest rate on its debt.  However, as discussed below, this is not imminent - there are no significant maturities until 2017, and extending maturities can be done gradually, mitigating the dilutive effect on FFO.

The most important decision facing management and the board is the means they choose to reduce debt.  I believe that ARCP can, over time, delever the balance sheet and achieve investment grade metrics by a combination of free cash flow and prudent asset sales.  Thus, I would advise management to defer the payment of dividends for as long as legally possible, and pay down debt over time with cash flow and selective asset sales.  In no event should ARCP issue equity to reduce debt.

Rufrano has properly acknowledged that ARCP has no immediate need to "do anything with the balance sheet."  As noted above, ARCP has no significant maturities until 2017.  ARCP is currently generating $700 million in free cash flow, and over $500 million after scheduled principal paydowns.  In addition, ARCP has over $11 billion in unencumbered properties.  In short, ARCP has sufficient cash flow and financial flexibility to gradually delever without diluting its common shareholders.

Sell side analysts are assuming that ARCP will issue equity to reduce debt, acknowledging that doing so will be dilutive.  The assumed equity raises have a material affect on the sell-side's later year FFO estimates, reducing 2016 AFFO estimates to as low as $0.70 per share.  Management would be derelict in its duties to shareholders to pursue this course.

Dividend Policy.  REITs are required to distribute at least 90% of their taxable income to shareholders annually in the form of dividends.  Thus, ARCP is constrained in how long it can suspend its dividend and apply free cash flow to debt reduction.

Based on management commentary, when ARCP reinstates its dividend, it will do so cognizant of the dividend policies of its peers.  In that regard, O's AFFO payout ratio is 84% and NNN's is 76%.  A payout ratio of 75% would allow a dividend of $0.60 per year, generating a 7.2% yield.  However, to the extent taxable income distribution requirements permit, a smaller payout ratio when initiating the dividend should be considered for the reasons stated above.

Possible Sale of Company.  On a more speculative note, I would not rule out a sale of ARCP after operations are normalized.  Rufrano has shown in the past that he is a willing seller, and he is now 65 years old.  I would expect that the reconstituted board would listen to credible offers, and the presence of Corvex does not, at a minimum, reduce the possibility of a sale.  It is not something I am counting on, and it is not necessary to the thesis, but I believe the odds are considerably higher than zero.

Risks.

The primary risk to the investment is rising interest rates.  The triple net sector is highly susceptible to increased rates - the leases have modest rent increase provisions, and the equities trade primarily as yield vehicles.  This risk can be hedged on a sector basis by shorting either O or NNN.

Other risks include poor execution by management of its business plan, and dilutive equity raises undertaken to accelerate deleveraging.

Catalyst

Presentation of business plan

Execution of business plan

Reinstatement of dividend

Possible monetization of Cole Capital

Speculative - sale of the company