by Travis Johnson, Stock Gumshoe | February 18, 2019 4:30 pm
Everyone was watching this week to see if Warren Buffett did anything big with Berkshire Hathaway’s (BRK-B) portfolio in the fourth quarter of last year, news that comes once each quarter (large investors have to file their end-of-quarter holdings in US stocks 45 days after the quarter ends), and… he didn’t.
Berkshire did add to its investments in the big banks, just like they did earlier last year, and they did sell a few Apple shares (about 1% of the position), though Buffett made clear later that this wasn’t a decision he made — the “core” Apple position is unchanged, which must mean that one of Berkshire’s other asset managers sold down part of his holdings to buy something else. If you want to have exposure to the big banks, Berkshire Hathaway has you even more covered than before… but otherwise, no real change. Berkshire shares tend to rise in the weeks leading up to the Annual Meeting (first weekend of May), but we’ll know more about the current state of the company when they report their next quarter (that next quarterly filing will probably come this weekend — Buffett prefers to report earnings on Fridays after the close, but the timing could certainly change). If there’s any upheaval or anything disappointing in the earnings, like a bad underwriting quarter,
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Innovative Industrial Properties (IIPR) announced this week that they are doing a debt offering, which has the potential to change the game pretty substantially.
Why does this change things?
Leverage.
If they can do 15% cap rate deals (meaning that the annual cash flow from the property is 15% of the amount they invested), and get debt financing that’s less than half that price, the margins improve considerably and cash flow ramps up rapidly. Real Estate Investment Trusts (REITs) almost always use a hefty amount of debt, and they use that debt to buy buildings with cash returns that are greater then the cost of the debt (or the blended cost of financing, since funds are usually from both equity sales and debt offerings), which means that as long as you can think of the debt as being somewhat perpetual (they won’t have trouble refinancing it), the cash flow rises on a per-share basis. REITs that are in the process of both growing fast, with high cap rate deals, and also levering up can have some extraordinary dividend growth… but this news came with a dilemma for me, because this comes just at the point that I was considering shaving some profit off in the high $60s, since the stock has really risen too far, too fast and gotten to a nosebleed valuation in terms of real operating performance and dividend yield (the dividend is now below 2%).
If they can get debt financing at reasonable terms, though, then the potential for much more dramatic dividend increases is even better than I expected and I may have to upgrade my “buy below” price or think about when the stock is really overvalued.
So what’s the deal? It’s sort of the first stage of becoming a “grown up” company that can issue debt on good terms. They issued exchangeable notes for $125 million, with a conversion price of just under $70 a share and an interest rate of 3.75%. That’s actually a good deal for the investors in this private debt placement, I’d buy that note (you get a higher yield than the common stock, plus senior position, and can exchange into the common at only about a 10% premium to today’s price), but it’s also reasonable for common shareholders and could provide a FFO boost over the next few years.
It helps to just think for a moment about how the business works. They sell equity (shares of stock) to raise cash, and use that cash to do sale/leaseback or similar deals with marijuana cultivation companies. Those deals have a cash return of roughly 15% a year, with built in price escalators that should make sure they keep up with inflation (as long as inflation doesn’t go bonkers, of course). The equity owners get a dividend, let’s call it 3% (it’s below that now, but they raised most of the equity at lower prices), so that’s the cost of capital. There is also a very small tranche of preferred shares outstanding with something like an 8% yield, but they’ve raised so much equity since then that it doesn’t make much impact.
The appeal of a company like this is that once they achieve scale, meaning they are big enough to cover their overhead costs (headquarters, employees, the cost of being a public company, acquisition-related costs for settlement, taxes, etc.), the cash flow from additional deals heads straight to the bottom line. For a triple-net-lease company (meaning the tenant pays insurance, maintenance and taxes), the costs shouldn’t go up dramatically as the portfolio grows — one management team can manage 30 properties as easily as 20. Their cost of capital is something like 3-4%, but the cash returns on their deals are 14-15%, which means that once the corporate overhead is covered that’s ~10% of the capital they invested being turned into annual free cash that’s available to pay dividends. If more of that capital structure shifts to being debt instead of equity, then that’s fewer shares among which the available dividend cash is distributed.
The reason it’s sort of a “junior” offering in this case, though, is that it doesn’t really get away from the dilutive effect of equity sales. IIPR has been financed almost entirely by equity sales so far, and they’ve still been able to raise the dividend because the cash returns on their deals are so high (a cap rate of 15% is exceptional, 5% is not at all unusual and 6-7% for an industrial building, which is mostly what these indoor facilities would be if they weren’t converged into giant grow houses, would be pretty good), so the appeal of debt would be that you get to finance with fixed terms and buy more properties at a net yield of 10%, say (14% cap rate minus 4% for the debt), and you get a nice big bolus of free cash flow per share (since you didn’t issue any more shares).
But this debt, since it’s convertible, is essentially the same, for our purposes, as issuing more equity — it increases the return for equity holders a little bit, but it also takes away some of their security… now that there’s a senior debt position, that’s who gets first call on the properties in the event of bankruptcy, whereas before the equity holders at last had the knowledge that there was no debt call on the properties so their shares couldn’t really go to zero. The benefit really comes if this opens up the debt markets to IIPR and they get to do a “real” bond offering at some point… and it’s unlikely that the bonds will be converted in the next couple years, so there is an interim bump to the funds from operations (FFO) per share as long as they can use this new chunk of cash to make new deals fairly quickly.
And they just announced a new deal last week, too, getting their first property in California — it’s a small deal, but it’s further evidence that the model still works because they’re still getting cash yields of roughly 15%… a good sign, since their last larger deal had been a hair lower at 14% or so, and they do have competitors (particularly some private REITs and institutional money) who are adding more capital to the real estate weed-funding business and are therefore likely to put some downward pressure on the cash yields. That’s OK to a limited extent, since they’re starting at such a high number, but it will become troublesome if the yield (cap rate) gets down to 10-12%. We’ll see how this year goes and what kind of deals they announce, but, on balance, I’m encouraged by the debt financing if it can help them grow more quickly.
The stock went down because of the offering, which does increase risk for shareholders (increasing return usually means increasing risk, of course), but it also popped right back up because IIPR is going to get some more “passive” buying — it was also announced that it will be added to the S&P Small Cap 600 index, which is not nearly as important as the S&P 500 but does certainly bring a fair amount of passive ETF money along with it.
This larger pool of capital, and the fact that deals are continuing to gradually roll in, further convinces me that they’re likely to be able to raise the dividend quickly. It might be that they will wait for a year to roll through, which would mean that the next hike isn’t announced until September, but they now have enough capital and enough cash-flow visibility that they could hike the dividend before that point if they wish to reward shareholders (and get their attention). I don’t think the stock is likely to surge higher than the $65-70 neighborhood before the next dividend hike, but with a reasonable 20% increase in the dividend my buy-up-to price can increase… I’ll go out on a limb and assume that they raise the dividend by at least 20% sometime in the next 6-9 months, which means that I can justify paying anything under $56 a share for a 3% yield and high dividend growth. Absent some surprising new deal, or a larger and sooner hike than expected, I imagine we will at some point hit market doldrums that bring the share down to the mid-$50s for that better buy point — the marijuana sector can certainly be explosive, so I could be wrong and maybe the stock will shoot to $100 from here just from that pot enthusiasm, but this is fundamentally a REIT and a finance company and the value of its properties and the size of the dividend should be an anchor at higher prices as surely as they form a foundation at lower ones.
So that’s still a hold in the $60s, but I am holding off on taking profits and will let it ride to see if it gets even more overvalued in the wake of index buying (or excitement about their next quarterly earnings report, expected in late March). I still like what they’re doing and I can now justify nibbling in the mid-$50s, with somewhat higher risk than it had before but also more financial flexibility.
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I’ve been playing around with a long-short Phunware (PHUN) position for a few months, since before the company went public through a SPAC merger, and noted a few weeks back that the price wasn’t making any sense — last week a WSJ story[1] called attention to the oddity of that price action (and Bloomberg covered it similarly[2] a few weeks ago), so, to reiterate: the stock price doesn’t always mean anything.
That was true to a more limited extent when Tilray (TLRY) first went public with a way-too-small float (“float” is just the number of shares that are actually available for trading), but it’s hugely amplified in the case of Phunware — that’s because they were very small when they merged with Stellar Acquisitions to go public through that SPAC merger… and though there were a decent number of shares outstanding, a lot of the SPAC shareholders redeemed for cash (a bad sign about the appeal of the transaction), so they ended up with most of the shares being held by insiders and therefore not initially tradeable. Add on that the warrants were also not exerciseable yet, because the new stock hadn’t yet been registered with the SEC (which always takes a little while for a SPAC deal, but was extended because of the government shutdown), and you have a situation when a blockchain-related stock got a tiny bit of attention and looked like it had a market cap of $50+ million, but only 20,000 or so shares were really available for trading and they kept changing hands back and forth, a couple thousand a day, at prices that had no real relation to the value of the company.
The price looked real, sure, but this is a lesson that sometimes the price isn’t real — it’s like that one car in the newspaper ad that the deal promotes as being an incredible deal, $10,000 cheaper than all the other ones you’ve seen… and it seems real because it’s there in black and white in the newspaper, but, when you get there, that particular car just happens >ahem!< to no longer be available (can we show you this creampuff that's so much nicer?). You need volume and free-trading shares in order to have a chance for the market to properly value a stock. The quoted price that we see in our brokerage account seems sacrosanct, like a fact that we can rely on, because for a "regular" stock there are hundreds of thousands of shares changing hands every day (or millions, in many cases), and there are huge wells of stock that are in the system with buy or sell orders within some reasonable range from the currently quoted price. But it isn't always real and it isn't always something you can rely on... sometimes it's just a number. Always check to see whether there's trading volume in the shares -- it helps to think of the number of shares trading times the price as the level of the "bet" that the market is making on the value of the stock -- 1,000 shares traded at $50 is $50,000 changing hands, maybe just one or two traders involved, which in the context of the stock market is like a bet on a lottery ticket being made by one guy with no teeth down at the convenience store... it shouldn't be interpreted the same as 500,000 shares traded at $50, which would usually represents a bunch of different people, maybe including institutional or professional investors, making a combined $2.5 million bet on what the price should be that day. Even a few million dollars is still "illiquid" in stock market terms, but $2.5 million worth of trading in a day should give you much more confidence in the price than $50,000 worth of shares trading. With small cap and microcap stocks, pay attention not just to the price quoted, but to whether or not the price is real. The simplest way to see this with Phunware, which I wrote about a while back and have had a long/short position on since before the deal was consummated and the name changed (it used to be Stellar Acquisition, the "blank check" company -- usually called Special Purpose Acquisition Companies, or SPACs), was with the warrants. There are a lot more freely trading warrants than there are shares, and the volume of warrant trading is much higher -- that means their vote means more. A 5-year warrant on a tech stock with some possibility of success should trade at a little bit of a premium, even if it's a relatively unimpressive company like Phunware, and the warrants have not traded anywhere close to their theoretical "real" value when you compare it to the equity. The warrants give you the right to buy the stock at $11.50 for five years... yet with the stock trading at well over $100 for a while (it has mostly ranged from $50-200, thanks to the complete lack of available shares for trading), the warrants were not valued as "deep in the money" warrants at the $90+ you might imagine, they were valued at 50 cents or 80 cents or something much more typical for a warrant that is near-the-money. That's the price the warrant should arguably trade at if the shares are at $9-10 and people are pretty pessimistic... which, sadly, means the equity is probably wrong and the warrants are probably right. So when you see disparity and want to figure out where the disparity is coming from, or which side is "right," look to the volume. I hear people saying they want to speculate on PHUN warrants, since they should be worth $40 if the stock price is at $50 and you can exercise them for $11.50, and yet the warrants trade at 50 cents... no brainer, right? Except the warrant price is more trustworthy than the equity price in this case, so the safer bet is that PHUN shares will probably run quickly back down to the $10 neighborhood, perhaps lower, as soon as those shares are registered and the insiders can start selling (and warrants can start being exercised... though, of course, if the stock is in free fall the warrants won't be exercised). That's not guaranteed, it's just the story the warrant price is telling me... and the warrant price is a lot more believable than the equity price right now. We'll see what happens as the shares actually get registered, which could happen anyday but will probably happen at some point in the next few weeks. I'd short more PHUN if it were available but, of course, it isn't... and this week I sold off enough of my warrant position to cover my cost, so I'll let the warrants ride and see if there ends up being enough magical thinking when those shares are registered to let them stay above the $11.50 exercise price. I'm skeptical, but you never know, maybe I'll get lucky for a few days. ***** "Cloud investment got ahead of itself" has been one of the dominant narratives in the tech investing world for a few weeks, driven by the huge investment by the big players (Amazon, Microsoft, etc.) but also by all of the hundreds of "cloud startups" that are spending heavily to build capacity and hoping to build businesses... and what that really means is "data centers got ahead of themselves." That was the story from Intel's conference call a few weeks ago, where they indicated that the rapid investment had led to a huge chip inventory glut among their data center customers that they have to work through, with similar caution from AMD and NVIDIA, and investors have extrapolated that out across pretty much any investment that's dependent on expansion or upgrades of data centers. Intel has said they expect to see data center chip sales pick up again in the latter part of the year, but, of course, there's no guarantee. That impacts Arista Networks (ANET) as well, of course, since their sale of switches depends on people wanting to build capacity in data centers... and they also see a wave of investment coming as the world gradually begins to upgrade to 400g switches from the current 100g standard in the next year or two... and therefore the Arista earnings were watched pretty closely this past week, as were those of much-larger-competitor Cisco (CSCO) a few days before. And surprisingly enough, both did just fine and were fairly optimistic about order flow on their conference calls -- apparently Intel chips were getting stockpiled, but customers kept buying switches and routers. Arista is still an expensive growth stock, but I've been impressed with them since I started buying on the dip last year... and I added slightly more to my position again after earnings at the end of the week. Following the optimistic commentary and guidance, and the raised estimates from lots of analysts, I can justify this stock up to about $260-270 (25X 2020 earnings, a little less than 30X 2019 earnings estimates), mostly because they still seem to be just started on their growth runway and there's no real pressure on margins, with their major competitor, Cisco, also doing very well. For earnings growth that's averaging about 15% a year, the valuation still makes sense -- it will still be risky and volatile, I think, and I probably wouldn't make ANET a large holding unless they had a bad quarter that shocked the shares lower, but this is worth a small position and I think the size of the opportunity they have over the next few years is still being underestimated. CSCO is definitely a safer bet, and is doing just fine as well with a lower valuation (it even pays a decent dividend), but ANET's growth potential is more dramatic. And that's it for your holiday weekend Friday File thoughts on the day — we’ve got a slow week of publishing to come as I’ll be spending some time frolicking with the little Gumshoes on their school vacation, but I’ll be back on Friday as usual to share whatever thoughts I’ve got with you, my favorite folks… I’m particularly thinking about the Fortnite buzzsaw that has been cutting the video game publishers down to size, and about what opportunity that might bring, but we’ve also got plenty of new teasers rolling through headquarters and perhaps one of those will spark an epiphany. Have a wonderful week, everyone!
Disclosure: Among the positions noted above my ownership should be clear (the portfolio I write about is a real money portfolio), but I should also disclose that I own call options on Intel, which was briefly mentioned, and own shares in both NVIDIA and Amazon, likewise mentioned in passing. I will not trade in any covered stock for at least three days, per Stock Gumshoe’s trading rules.
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