Description

I recommend BUYing Commonwealth REIT 6.5% Series D Convertible Perpetual Preferreds (CWH.PD): 

CWH has 15.18 million Series D Preferred shares outstanding with a par value of $25.00/share.  At $22.82 they are currently trading at a 7.1% yield which is in-line versus other REIT comps (see ARCPP writeup).  However, the primary reason to BUY is the fact that the Series D have a “Special Conversion Right Upon a Fundamental Change”.  A Fundamental Change includes a “Change in Control” which, for Series D, includes if existing trustees at issuance (or voted on by majority of existing trustees) cease to make up the majority of trustees (note that the Series E Preferreds don’t have this particular feature).  A successful Consent Solicitation by 2/3rds of shareholders (ongoing ending 3/19) to remove all existing CWH Trustees would trigger this Change of Control and Conversion Right.  The Conversion Right allows a holder to receive common shares worth ($25.00+accrued)/.98 = $25.76-$25.91 per $25.00 of liquidation preference or $25.00 (+ Accrued) = $25.24-$25.40 in Cash per $25 of liquidation preference at the option of CWH.  This is a 10.6-11.3% return in cash (or 12.9-13.6% return in shares) in 45-80 days (61-126% annualized).  And if the consent fails you are holding a preferred with 7.1% yield which is in-line with comps, although given the poor corporate governance and relative credit ratings they are likely to trade down ~7%, to yield 7.7%, in-line with their Series E. 

Background:

Corvex(run by Keith Meister, formerly at Icahn) & Related(Jeff Blau) hold 9.6% of the shares and have been trying to hold a Consent Solicitation (to remove all current CWH Trustees) since filing a 13D on 2/14/2013.  The Commonwealth trustees had put in place a number of by-law changes that made it virtually impossible for a Consent Solicitation to occur, as allowed in their declaration of trust, but Corvex/Related won an arbitration ruling in November that has allowed it to now take place.  A record date was set for 2/18/2014, with a 30-day solicitation period ending on 3/19/2014.  Commonwealth then has 5 business days to inspect the solicitations and declare the results (until March 26^th).  Two-thirds of shareholders (118,401,258 total common shares outstanding on Record Date) need to vote in favor in order to remove all trustees.  If the Solicitation is successful and the Trustees are removed, a “Fundamental Change”/”Change of Control” will have occurred.  The company must state within 15 days of the Fundamental Change what option (Common Shares and/or Cash) shareholders will be able to convert their Series D Preferreds to, as well as set a Conversion Date for 20-35 days later.  A holder of Preferred Series D shares will then be given the option to exercise their “Fundamental Change Conversion Right” for common shares with a value on Conversion Date of ($25.00+accrued)/.98 = $25.76-$25.91 per $25 liquidation preference (depending on accrued at Conversion Date).  The market price used for the conversion is the average of the closing prices on the 5 trading days ending on the 3^rd trading day prior to the Conversion Date (so there is some market risk and/or hedging necessary, thus the 2% discount versus cash).  The company has the option to instead pay in Cash of ($25.00+accrued) = $25.24-25.40. 

I won’t go into too much more detail here on Commonwealth REIT (CWH) itself or the reasons for the attempted removal of all the Trustees.  Most people are familiar with CWH at this point, and if not you can refer to Corvex/Related’s many presentations/filings from the past year for detailed background info of the business and management: 

Website:  http://www.shareholdersforcommonwealth.com/

Detailed Presentation including Valuation and Comps: http://www.shareholdersforcommonwealth.com/wp-content/uploads/2014/02/Consent-Solicitation-II.pdf 

Consent Solicitation: http://files.shareholder.com/downloads/HRP/2853482611x0xS1193125-14-24488/803649/filing.pdf

Odds of Success:

Positives:  Corvex/Related previously attempted a consent solicitation ending June 18, 2013 and said they had received solicitations from 70%+ of shares in favor of the consent (with >2/3rds needed to succeed).  (This solicitation followed the original bylaws in place before CWH changed many and made it virtually impossible for shareholders to call a consent solicitation.  This solicitation was later ruled by an arbitration panel to be invalid, but many of CWH’s bylaw changes were struck down as well and an official consent solicitation has now been allowed to proceed.)  Some shareholders may not have voted last June due to confusion of whether or not it was even a  valid consent solicitation (as the company said it wasn’t, and didn’t set a record date for the vote).  Importantly, in addition to allowing a New Consent Solicitation to proceed, the arbitration panel only made it an interim ruling in November and remains available to settle any disputes that may arise until the completion of the Consent Solicitation in order to ensure a fair and equitable result.  Additionally, and very importantly, two weeks ago Corvex got Sam Zell and David Helfand to agree to be Chairman and CEO respectively if the current board is removed in the consent solicitation.  This should help sway some shareholders who may have been on the fence and has also made it impossible for the Portnoy’s to credibly disparage the potential Corvex-backed management; they now only question “how much time he may be willing or able to commit”.          

Negatives:  Insiders (Portnoy’s and the Trustees) only hold 0.37% of outstanding shares, however Vanguard now holds 14,632,398 shares (12.36%) as of 12/31/2013, up from 13,050,500 at 11/30/2013.  Vanguard owned 9.5% during the last (later invalidated) Consent Solicitation in June, but were given a waiver on 8/2/2013 by CWH that they could own up to 20% (everyone else is limited to <9.8% by poison pill).  Since the Portnoy's know how shareholders voted in June, it seems extremely unlikely that they would have given this waiver unless Vanguard had voted to keep the Portnoys.  Additionally, Vanguard purchased 3.2M shares in the quarter ending 3/31/2013.  There was a large secondary offering at $19 during that quarter and while Vanguard only provides end of month holdings I assume they got all of these in the offering (while Corvex claims they weren't able to purchase a  single share in the offering even though they bid up to $27; it was 4x oversubscribed at $19).  So >2/3rds vote is needed to remove the trustees and Corvex said they got 70%+ in June solicitation, but Vanguard now holds 2.86% more than they did then.

Estimated Odds: I think it’s ~75% likely that Corvex wins the Consent solicitation given the previous vote, the current shareholder base, the Sam Zell factor, and the Arbitration Panel’s availability to settle any disputes and make sure it’s a fair vote. 

Valuation:

Upside: ~75% estimated odds (success of Consent Solicitation).  Will know success/failure in <30 days.  Dividends are payable on the 15^th of February, May, August and November.  So there will be 54-89 days of accrued on the Conversion Date and a 1.625 annual dividend payout = .24-.40 of accrued.  Assuming a cash payout a shareholder would receive $25.24 - $25.40 = 10.6-11.3% return in ~45-80 days (61-126% annualized).  Assuming a common stock payout, a shareholder would receive common shares worth ~2% more than this on the Conversion Date.   

Downside: ~25% estimated odds (failure of Consent Solicitation).  Shareholders would be left with a preferred yielding 7.1%, which is in-line with comps, although with poor corporate governance (although some minor improvements the past year) and Baa3 credit ratings by Moody’s it would likely trade down some.  The Series D Preferreds have traded between $20 (Nov 2011) and $24 in the 2 years prior to the initial Corvex 13D last February.  The Series E, which doesn’t have the conversion feature, is trading at a 7.7% yield currently.  Assuming the Series D trades for a similar yield (7.5%-7.8%) following a failure you get a downside to ~$21-22 = 5-9% downside.                     

Credit Rating on CWH Debt:

Moodys:                Unsecured Debt:  Baa3 (Preferred: Ba1)

S&P:                      Unsecured Debt:  BBB- (Preferred: BB-)

CWH Capital Structure (est current adjusted for Assets Sales) and Cap Rate:

Cash NOI (TTM Adjusted for Asset Sales and including NOI from Discontinued/For Sale):  $463M

                                                Amount                  % of EV                   Cap Rate

Cash                                        $297

Debt                                        $3,115

Net Debt                                  $2,818                   42.6%                      16.4%

Preferred                                 $655                       9.9%                       13.3%

Common                                  $3,148                   47.6%                      7.0%

Total Enterprise value             $6,621

Preferred:            

                               Shares                   Par                       $Outstanding         Price                      Coupon                    Yield

Class D:                  15.18M                  $25.00                   $379.5M                $22.82                   6.5%                       7.1%

Class E:                  11.00M                  $25.00                   $275.0M                $23.55                   7.25%                     7.7%

Total:                      26.18M                                                $654.5M

Catalyst