Description

Introduction

PMC Commercial Trust (PCC), a commercial mortgage REIT, is a deeply undervalued stock that is ripe for shareholder activism.  I am currently in the early stages of organizing such an activist effort.  The stock closed at $6.88/share today and has a tangible book value of $13.38/share.  A simple discounted cash flow analysis shows it would be worth around $12/share today if a plan were announced to liquidate the assets by allowing the loan book to gradually run off and pay out all cash flow to equity and debt holders over time.  The next annual meeting is in early June 2013, so if it takes around 6 months for the activist effort to succeed in closing the gap between $6.88 and $12, that would represent an annualized IRR of around 149% per year.  But besides offering a very attractive annualized return if things go well, this investment is also very low risk because (a) the stock is trading at a P/TBV of around 0.5x, (b) the loan book is high quality, (c) the capital structure is severely under-leveraged, (d) the dividend yield is 7.0% (and it should be sustainable), and (e) the stock has *negative* interest-rate risk (negative duration)  – that is, the stock price and dividends will *increase* if interest rates rise – because the assets consist primarily of variable rate mortgages.  That means PCC is an attractive income-oriented investment even if the activist effort fails.  So: if very-high-potential-annualized-return / very-low-risk investment ideas appeal to you, please read on…

Failed strategic review

The stock price plunged recently on news that their strategic review, where they were primarily negotiating with an unnamed party who was interested in buying out the company, had failed to produce a transaction.  They also announced a 25% dividend cut, to $0.48/share annually, and that their CEO, Lance Rosemore, had been replaced by the former COO, Jan Salit.  In the press release, Mr. Salit says “while our current business plan has been successful and stable, it is our intention to embark on strategic growth initiatives to build shareholder value”.   Great.  In my discussions with management, I have been unable to learn anything more about why the potential transaction wasn’t completed.  Luckily the only “growth initiative” they’re seriously considering at this time is to increase the maximum size of the SBA 7(a) loans they originate.  The truth is, as I’ll explain in more detail below, the economics of this company have been broken for many years now.  So it’s pretty obvious that, unless you’re one of the executives making over $0.4M per year running this company, it makes a whole lot more sense to liquidate the assets by letting the loan book run off and paying out the cash to equity and debt holders.

Why is this business broken?

There are basically three reasons: leverage, scale, and extremely low short-term interest rates.  Ever since the financial crisis of 2008/2009, PCC lost access to the asset-based securitization (ABS) market that was a crucial source of low cost and long term funding.  As a result, the aggregate size of their loan portfolio has been in decline as they’ve paid off their ABS debt.  At this point the company has a debt/equity ratio of $59.3M / $142.6M = 41.6%, which is extremely low for a finance company, and that’s one reason why the ROE of reinvesting paid-off loan principal back into new loan originations is unattractive.  Another reason, which is related to the above, is that their scale of operations has become too small to support their relatively high levels of corporate overhead.   For example, in the 9 months ended Sept. 30 of this year, their G&A plus salary/benefit expenses amounted to 38% of total revenues.   Finally, ultra-low short-term interest rates have contributed to all of the above since their loans are primarily variable-rate mortgages tied to LIBOR that now generate much less income than they did before the financial crisis.  So given all of the above, and the fact that the stock trades at $6.88 even though it has a TBV of $13.38, hopefully it’s clear why I’m saying that liquidation is clearly in the best interests of the shareholders at this point.

Rosemore family

The former CEO, Lance Rosemore, was given a $2.2M severance package and is now bound by a non-disparagement agreement with the company.  I have been unable to learn anything more about why Mr. Rosemore was replaced, other than that it was a “mutual decision”.  I believe this leaves the Rosemore family very little formal control or oversight of the company, which is significant because up to now this company had been very much under their control.  To the best of my knowledge, the only remaining Rosemore family influence is Lance Rosemore’s sister, Dr. Martha Rosemore Morrow, who is on the board of directors and owns around 3.4% of the outstanding shares.  I am in contact with a member of the Rosemore family, and based on the initial response I believe there is a good chance they would support my proposal to put this company into run off.  It is my understanding that the Rosemore family and their friends/associates own between 15-20% of the outstanding shares, so if they can be brought fully on board with this activist effort then the probability of success would rise significantly.  Some additional background on the Rosemore family and the history of this company can be found in david101’s VIC write-up on PMC Capital back in 2002.

Board of Directors and executive management ownership

According to the 2011 proxy statement, the board of directors and executive officers as a group control 4.5% of the outstanding shares, and that includes the shares owned by Martha Rosemore Morrow.  As indicated above, I have reason to believe the Rosemore family would be inclined to support my run-off proposal, and she owns 3.4% of the outstanding shares, so that leaves only 1.1% of the vote controlled by the remaining members of the board and executive management.

Previous activist effort

Several years ago there was an effort to force change [http://www.bizjournals.com/dallas/stories/2009/06/08/story3.html], either by improving operations or liquidating, by a group led by Bob Stetson that purchased 4.5% of the outstanding shares.  This effort ultimately proved to be unsuccessful and they sold most if not all of their shares.  However, it appears Mr. Stetson is getting back in the game and has started buying shares again.  I’m told that his group now owns about 2% of the outstanding shares and is interested in buying more.  Mr. Stetson is not convinced at this point that liquidation is the best possible course to take with PCC, but he’s clearly interested in taking some kind of action to unlock shareholder value, and I hope to work with him constructively in the future.  

Runoff analysis

The following analysis is intended to show why I believe this company is worth $12/share in a runoff.  This analysis is based off the cash flow and income statements from the Q3 form 10-Q:

The first part of the analysis reconciles what I’m calling “Adjusted Cash Flow” with reported Net Income.  The adjustments I make are similar to what’s done in the cash flow statement, but I’ve eliminated the “premium income” generated by originating and selling the guaranteed portion of SBA 7(a) loans since there would be no such income in a runoff.  I’ve added back the non-recurring expense due to the strategic review process itself (which basically consumed all net income for the first 9 months of 2012).  I’ve also assumed that 50% of the G&A plus salaries/benefits could be eliminated in a runoff.  This is a very rough guess and I’d be interested in feedback on whether this seems like a good assumption.  I suspect the savings could be even greater if the company were delisted from the NYSE and operated as a very low-cost private company whose stock trades OTC (i.e., the pink sheets).  I’m thinking there would need to be a few people who service the existing loans and process any foreclosures/REO when necessary, an accountant to keep the books in order, and an operating manager to oversee the overall operation. 

Using the above assumptions, the current portfolio would initially generate annual cash interest plus other income of around $7.3M per year.  However, what’s far more interesting is that the first year alone should generate around $26.1M of principal repayments, which means there would be a total of around $33.4M of cash gushing into the company in the first year.  If we assume that debt owed by the company is paid down at the same rate as the debt held by the company is paid off, then $7.6M of debt would need to be paid down in the first year, which leaves $25.8M available for the first-year dividend, or $2.44/share.

Now I’d suggest that the reader stop and think about that for a second.  Remember, the stock trades at around $6.88/share today with an expected annual dividend of $0.48/share.  What do you think would happen to the stock if this runoff plan were announced and the first year dividend was estimated to be around $2.44/share?  I’m guessing the stock would immediately jump to around $12/share, which is the present value of all future dividends assuming a 7.5% discount rate and a 12.8% annual decline rate. (That is, $2.44 / (.075 + .128) = $12.02).  The 12.8% decline rate is derived as the ratio of principal repayments to outstanding loan principal during the first 9 months of 2012.  Note that this formula assumes all expenses and revenue decline at this same 12.8% annual rate going forward, including G&A plus salaries/benefits.  Clearly this is an oversimplification of reality, as there are certainly some fixed costs that won’t scale down so nicely, but I think this $12 valuation is reasonable because (a) the equity has a tangible book value of $13.38/share, so my valuation is less than 90% of tangible book, and (b) I think the initial G&A + salaries/benefits can be cut more than the 50% I’ve used in this calculation.  I would also note that my assumed 7.5% discount rate exceeds the current dividend yield of ~7.0%.  If I use a 7.0% discount rate instead, the runoff fair value increases to $12.32/share.  

Future plans

As of today, I own around 0.4% of the outstanding shares of the company and may increase my position in the future.  And although this is a significant position for me personally, I clearly don’t own enough shares to influence the board of directors on my own.  I’m going to need a lot more “muscle” to stand with me.  In addition to some of the individuals and groups discussed in this write-up, I’m in contact with another individual who owns about 4% of the shares and, as of the last time I spoke with him, he was at least 50% on board with my plan to force the company into runoff.  So I guess the bottom line is that I’ve gotten a significant amount of interest in this plan from some important players, but I don’t have any firm commitments yet and I haven’t started publicly pressuring management or the board of directors. 

So that brings me to one of the reasons I’m writing this up on VIC.  See, this sort of reminds me of George Soros’ “Theory of Reflexivity” – if this investment idea is *perceived* to have a lot of merit then that might actually *cause* it to have a lot of merit, since I’ll have more shares on my side if people in VIC-land buy shares and join with me.  So if anybody out there either already owns shares or buys shares after reading this write-up, please let me know.  If I can get a significant percentage of the shares on my side, then I plan on starting an activist campaign similar to what Nawar Alsaadi and I have done with EQU.  In that case, having around 20% of the shares working together as a group was enough to pressure the board of directors into taking shareholder friendly action; there hasn’t yet been a need to actually launch a proxy contest and elect a new board of directors for EQU, but the implied threat of doing so serves an important function.  I’m hoping that a similar public activist campaign for PCC will force the board of directors to do what’s right for the shareholders, which is either (a) put the company into runoff as described in this write-up, or (b) sell the company to whichever interested buyer it was that caused the strategic review to be initiated in the first place.

Catalyst