Before we talk about the warrants, it is critical that we discuss the underlying stock and the business. Then I want to review whether the stock makes for an attractive investment and if buying the warrants is a better option. I know I gave my conclusion away with the heading of this review but I do want you to follow through with this analysis to make sure the reasons are well understood. Keep in mind that the REIT units (stock) trades under the symbol ROIC and the warrants under the symbol ROICW and either the stock or the warrant can be purchased at any broker using the ticker symbols above.
I have posted a longer explanation of warrants you might want to read.
Retail Opportunity Investments Corp Background
Retail Opportunity Investments Corp. commenced operations in October 2009 as a fully integrated, self-managed real estate investment trust, or REIT. The Company specializes in the acquisition, ownership and management of necessity-based community and neighborhood shopping centers in the western and eastern regions of the United States, anchored by national and regional supermarkets and drugstores.
The Company targets high quality necessity based community and neighborhood shopping centers anchored by national and regional supermarkets and drugstores that are well-leased, with stable cash flows. Additionally, the Company acquires shopping centers which it believes are candidates for attractive near-term repositioning or present other value-enhancement opportunities. Essentially, ROICs modus operandi is to buy up otherwise great assets at below market prices by looking for distressed sales such as foreclosures, lender owned or where sellers are either in default or unable to refinance. It also seeks out properties that may be undervalued in the market due to design flaws or other issues that it can quickly fix upon acquisition.
From the commencement of its operations through December 31, 2011, the Company completed approximately $626.0 million of shopping center investments. As of December 31, 2011, the Company’s portfolio consisted of 30 wholly-owned retail properties totaling approximately 3.2 million square feet of gross leasable area, or GLA, two retail properties owned through joint ventures, encompassing approximately 500,000 square feet of GLA and a 50% interest in a B-note of an existing promissory note secured by a 407,952 square foot shopping center.
Key Performance Indicators
ROIC has a 2 year operating history but its management has been in this business for over 20 years. Since the company started operations, it has been building up its portfolio of assets aggressively and it is still growing. 91.2% of the gross leasable area is leased and with stable anchor tenants, it has built up a steady cash flow.
For REITs, Funds from Operations are a more meaningful metric then Earnings per share, as it removes the effect of the non cash depreciation charges of the real estate assets. The following table lays out ROIC’s operations since inception:
|Revenues (mm)||$ -||$ 16.30||$ 51.70|
|EPS||$ (0.19)||$ (0.01)||$ 0.23|
|FFO/Share||$ (0.18)||$ 0.16||$ 0.71|
|FFO Growth Rate||344%|
At the current prices, the company has a market value of $587 million and a Price/Book of 1.30. The stock closed on Apr 10, 2012 at 11.88/share. The stock also pays a dividend of 0.12/share quarterly or a 4% yield.
A few quick calculations are in order. The company earned lease and rent revenue of $51.7 million in 2011. Of the total $626 million the company has spent in acquiring properties, $392 million was spent in the year 2011 spread out over the course of the year. A quick approximation (assuming acquisition spend was uniformly spread; even if it was not, it does not make much of a difference in the conclusion) would be an investment of (626 – 392) + 392/2 = $430 m yielding $51.7 m in revenues or a 12% yield. If the company were to stop making any further acquisitions or any other value enhancing activities, the 2012 revenues will climb to 626 * 12% = $75 m or about a 23% increase and more dividend growth will be seen. The dividend yield could grow to 6% based on a $12/share stock price (we will see shortly why I am using this particular number). Remember, REITs are required by law to pay out 90% or more of their cash flow as dividends.
However, the company has raised funds in new stock offering as recent as Dec 2011 and intends to continue the growth. The company also maintains a good mix of short term and long term leases for predictability and the opportunity to raise the lease rates with inflation and leasehold improvements. So I expect that the revenues and the dividends will rise at a better rate in the next 2 years.
The Stock is a Good Value But Is Not an Attractive Buy
This is because it is certain that the stock will be diluted. Let me explain.
The company has 49.4 million shares of common stock outstanding. The company also has 49.4 million warrants outstanding that give the holders of the warrants a right to purchase 1 share for each warrant exercised at $12/share. The warrants can be exercised any time before Oct 23, 2014, after which they expire.
The stock price today is almost $12/share and the warrants are trading at around $1/share. These warrants act like a long term option so part of the value is the time remaining till the date they expire.
How does this work?
Any time before Oct 23, 2014, if the stock price rises above $12, it might become attractive for the warrant holders to exercise the warrants. If you buy the warrants today at $1/wts and the stock price rises to $14 (for example), it is profitable for you to exercise the warrants and pay $12/share for the common stock (that the company will issue new to you in exchange for your $12) which you can immediately resell in the secondary market for a quick $1 profit ($14 (sale of the stock) – $1 (you paid for the warrants) – $12 (you pay for the stock upon exercise) = $1 profit). Why wouldn’t you? This is a 100% gain on your purchase of the warrants, even if the stock price has only risen by 17%!
What does this mean?
This means 2 things:
- Every advance in the stock price above $12 will be met with some warrants being exercised which will add more shares to the float thereby diluting the existing shareholders. This will act as a drag on the stock price
- If the stock is a great value, warrants offer a better return on the investment at the same risk of capital loss (or gain). It may be more volatile than the stock, especially since the stock appreciation will be artificially dampened. As we saw in the example above, a 17% upside in the stock price may mean a 100% upside in the warrants.
This does not mean that the stock cannot appreciate if the business grows in value. It certainly will, since there will be buyers of the warrants at prices higher than today’s that may not find it economical to exercise. So 100% dilution is the extreme case, which may never be reached.
Also keep in mind that the company has the right to force warrant holders to exercise their warrants if the stock price is above $18.75/share.
Few Other Things to Keep in Mind
- Warrants can be bought and sold on their own. They do not have to be exercised. The price of the warrants will be correlated to the price of the common stock to a large degree
- The company is trying to come up with a plan to either buy out the warrants or make an offer to the warrant holders so they can get rid of these “pesky” warrants that limits shareholder wealth creation. So they might make an offer to buy out the warrants at some premium in not too distant future to remove the drag on the stock. If an offer is made, I expect it to be lucrative (20%-25% gain in a few months to a year is not bad).
- When the company pays a dividend, the stock price declines by the dividend amount but the strike price of the warrants do not change. So in theory the company can pay large dividends on the common to make sure that the common stock does not go above $12 for the next 2.5 years and the warrants expire worthless. In practice, it is not feasible as a large dividend yield will draw many new investors to the stock and the price will rise
This analysis has been focused much more on the financial instrument to use rather than the fundamentals of the business and there is a good reason for it. This is a special situation where the profit is in the situation, although we do need to be certain that we are not backing the wrong company.
The fact that the stock price is almost $12/share (the strike price of the warrant) and there is still 2.5 years to go before the warrants expire, means that there is sufficient margin of safety available to us.
Buy the ROICW warrants at any price below $1/warrant. Target sale price is $3/warrant. Holding target is about 1 year. Keep your exposure to less than 5% of your portfolio (ideally about 3%).