Description

U.S. Restaurant Pfd A is a NYSE-listed stock trading at a 14.5% yield ($1.93 dividend, $13.75 price, $25 par value). This yield is nonsensical given its low level of risk. The security has excellent cash flow and asset value coverage; there is no reasonable scenario in which the dividend would be at risk. Further, the company is currently operating in a run-off mode, which is further reducing risk. Buying USV Pfd A at $13.75, less the 48 cent dividend that will be paid soon (stock goes ex in late November), effectively creates the stock at a 14.5% yield. It should trade at a much more reasonable yield of say 10%; if it takes 3 years to reach that yield level (hopefully it won’t take that long), your annual compound return would be over 25% -- excellent for a low risk current pay security. Even if the stock price is merely flat, you still earn 14.5% currently.

US Restaurant Properties (USV) is a REIT specializing in owning well-located chain restaurant and gasoline retailing properties, which are then triple-net leased back to the operators of those businesses, generally for 15-20 year periods. USV simply owns the underlying real estate for these businesses and collects rents from the entities that operate the restaurants and gas stations. In total they own over 800 properties, with the largest concentration being Burger Kings.

Historically USV was involved only in financing chain restaurants, and continues to be quite successful with that business (USV’s co-founder and CEO until last year was formerly the CFO of Burger King). But as the restaurant finance business got more competitive in 1997-98, and under pressure to grow, they branched into the financing of gasoline retailing properties. The combination of doing a few bad gas station deals, along with the severe contraction in the small-deal securitization business in late 1998 (which we view as a major positive), led to some asset write-downs and an end to the idea of USV being a growth stock. USV common fell from $30 in mid 1998 to as low as $8 in early 2000 and USV Pfd A fell from $28 to as low as $9 in the same time frame.

Both the common and the preferred have recovered somewhat as the company has essentially resolved its gas station portfolio problems over the last 2 quarters, shrunk its portfolio and paid down debt, basically eliminated its entire acquisition staff, and changed its profile from a growth company to a steady dividend payer (the company has even recently moved to the paying of common dividends on a monthly basis to emphasize its appeal to income-oriented investors as a steady dividend payer).

Here’s the capital structure of USV:
USV Common stock: 17.5 mm fully diluted shares (you have to be careful with common shares to include: 1) publicly traded common stock, 2) private “operating partnership” units which are equivalent to one share of common stock each, and 3) contingent shares to be issued to former management company) * $10 per share = $175 mm of common equity market value.

USV Preferred Series A: 3.68 mm shares * $13.75 = $51 mm of preferred equity market value. (This is the security we are interested in; while the common also has a high dividend yield, the preferred has much better cash flow and asset coverage than the common. The preferred dividend must be paid in full before either common or operating partnership distributions can be made.)

Debt: $356 mm debt carried by USV, plus $55 mm of subsidiary preferred stock which we treat as debt. So the total debt is really about $411 mm.

Excluding nonrecurring items, and consolidating the minority interests (which we believe to be appropriate), EBITDA is running at about $71mm/year. Against that, maintenance cap exp is $2mm, interest expense is $36mm. So they generate about $33mm of free cash flow to pay dividends. The Preferred only requires $7mm of such cash flow to be fully paid. The rest is available for debt repayment and common dividends. Consider that in order for the preferred dividend to be at risk, over 1/3 of USV’s triple net leases would have to stop paying entirely &-106; very implausible!

What are the net assets of USV worth? Info from industry sources suggests that in a bulk sale, the leased properties would sell for between a 10% and 12% cap rate. Using the more conservative 12% cap rate we compute a gross asset price of $612mm based on annualized net rental income of $73mm, plus $70mm of cash, receivables etc., less all liabilities of $433mm (which includes all liabilities except deferred income, plus it includes $55mm of subsidiary pfd as noted above). This results in equity of about $250mm to cover the USV preferred, vs a par value of the preferred of $92 mm and a market value of the preferred of $51 mm. Since this is an inherently stable asset class, and we used conservative valuations, and management is shrinking rather than growing the asset base, we are comfortable with the amount of cushion for the preferred. (Also note that a more likely sale scenario is for the company to over time pursue a slow liquidation of the properties in the 1031 tax free exchange market which has consistently resulted in the company selling medium quality individual properties at 8-9% cap rates.)

There are several catalysts for the investment.
1) First, by our way of thinking, a 14.5% current yield is a catalyst for investment return all by itself (even if you do not get a capital gain one day), as you are getting paid currently to own a security.
2) A combination of progress on resolving their few portfolio problems, continuing to pay down debt (another $30-60mm of net debt reduction is forecast for the next 6-12 months), plus holding their dividends steady and marketing themselves toward income-oriented investors, will attract more investors to the high yield. (Also note each preferred share is convertible into .94 shares of common.)
3) The refinancing of their debt in the first part of 2001 should remove any remaining significant risk in the situation. USV has a significant amount of their debt due in January 2001, and they are in the process of refinancing that plus all other debt that is due within the next 3 years. USV recently signed a letter of intent with Bank America for such refinance. (Even if such deal falls through, the asset and cash flow coverage is such that we have little worries about this getting refinanced by somebody.)

Catalyst

14.5% current yield; company taking actions that should lead to market waking up to the low risk in the security, it should then reprice upward.