by Travis Johnson, Stock Gumshoe | May 10, 2019 4:01 pm
I’ve got a new buy to go into in some detail today, but first let’s go through some meaningful earnings reports that shook up the Real Money Portfolio this week and sent some questions my way…
The Trade Desk (TTD) beat the analyst expectations for both revenue and earnings this quarter, but not in a hugely dramatic way and still showing evidence of the fact that the growth is slowing down a bit as they get bigger… which is a natural and expected occurrence.
The shares were initially a little weak in the pre-open trading thanks to the flat forecast for the second quarter, though they did raise their expectations for the full year. When a stock is trading at this kind of nosebleed valuation, you really need to shock investors with growth to keep the shares going, and we had gotten used to that because TTD had been in a habit of offering very conservative guidance that led to some dramatic “beat and raise” quarters in the past, but this “beat” was more subdued and that might well have been what got the worries started. Expectations matter.
But that was just the initial reaction to the numbers before the market opened on Thursday… the reaction a little later became much more dramatic, which means, to me, that maybe investors started to freak out about CEO Jeff Green’s comments on the conference call about spending more money to grow market share in programmatic advertising.
Why? I don’t know. Perhaps those who were clambering all over this as a oft-repeated recommendation of the Motley Fool thought that TTD had somehow magically become the only ad-tech company around, or was going to get a pass on taking over the world. That never happens, or if it does happen it’s an accident… and, well, investors are freaking out this week in general and this is a stock that has quadrupled in value over the past year (and more than doubled just since January), growing the stock price far faster than the underlying company could grow the business, so volatility comes with the game. When a stock doubles in a couple months, you attract investors who are expecting dramatic things every time a new quarter is released, and this quarter, while very good, was not at dramatic in the context of TTD’s past performance.
Still a great company, still a pretty insane valuation if you use the PE ratio for this year or next year, and being worthy of that valuation depends on rapidly rising revenues from their advertising partners as programmatic advertising takes over more and more of the market (most of their customers are ad agencies, though companies also run their own advertising campaigns)… and the challenge is still probably mostly competition as they try to take leadership of the “open internet” and wrest power away from both their smaller ad-tech competitors and the huge “walled garden” marketplaces (Facebook and Google, mostly).
The Trade Desk is growing fast, the market it operates in is growing fast, management is incentivized to grow and they’ve built something gigantic very quickly, and to some extent it could be built on quicksand. This is a technology company that provides a service to a relatively small number of advertisers… if a better product comes along, they can lose.
I don’t think they will, and I love their continuing push to integrate the “open internet” with their shared cookies, which seems to be getting some traction with big advertising groups and networks, but I am, of course, watching the stop loss trigger point for these shares because it’s a momentum stock with a crazy valuation, and big sentiment swings can easily cut the shares in half even without a major failing or a “miss” on the part of the company. Because we have to be prepared for volatility in stocks that have surged this much, the stop loss trigger is way down near $120 a share… I don’t expect we’ll hit that, there was no actual bad news in this report, just a fear from investors that growth won’t be as fast as they hoped, so I think I’ll just be watching for a while.
The key reasons to hold on, I think, are the excellent management team and the massive size of the market, combined with the clear scalability of the business (which is mostly providing software subscriptions and access to data)… the cost of providing the platform for their actual product offerings is fairly low, giving them a gross margin of 75-80%, but we really want to see whether they can continue to grow profitably without having to invest too much more and more in sales or overhead — and so far they have. This quarter they spent a little more, and it sounds like they want to spend still more on expansion if they can find things to spend that money on, so the company will probably want to continue to be evaluated as a revenue growth company and not an earnings growth company, which will offend some folks, but it’s clearly working pretty well.
They’re still tiny relative to the addressable market, but they have pretty quickly sucked up a lot of the oxygen in the programmatic advertising market with their relationships with large advertisers and their strong customer retention, so they may well be able to continue leading… and they don’t need money, which is a competitive advantage over some of the smaller upstarts — they are profitable and can self-finance this continuing aggressive growth, particularly into Europe and Asia, even if they choose to reinvest those profits instead of reporting them.
I really like CEO Jeff Green and his vision, and that’s a subjective determination but it’s also not a small thing — confident leadership with a bold vision of the future is part of the difference between Netflix and Blockbuster. It doesn’t mean they’ll keep winning, and the stock price could certainly fall if they have a bad quarter (it has in the past), but for me this has been a hold all year simply because it is already such a large part of my portfolio… if I did not own any shares, I’d probably consider a small nibble here after this dip if you’re interested in the five-year story.
It turns out that I was right to be a little nervous about the run up into earnings last week, and the better short-term decision would have been to take a little profit off the table, but that kind of short-term sentiment-based trading is usually a mistake (which is why I try to resist it, not always with success). I don’t think The Trade Desk is done growing… the stock got a little too high in expecting another dramatic “beat and raise” this quarter, but the company itself is still doing the right things and still showing strong performance in every real way. It’s not cheap, it’s not an easy buy even at $180, but if they keep doing things right they’ll keep growing into that valuation and moving the yardsticks, so it’s not likely to ever be cheap enough to be “easy.”
Innovative Industrial Properties (IIPR), another top-ten position in the Real Money Portfolio released its quarterly earnings, and it was more of the same… which means no big impact on the stock price this time around. They reported more of the dramatic growth in funds from operations (FFO) per share that we’ve come to expect, 28% growth just since the last quarter and 84% year over year, mostly because they’ve been adding new sale/leaseback deals each quarter and some of the deals they signed last year are just beginning to pay rent now. None of that is super sexy for a marijuana stock, most of which are showing huge revenue growth from very low starting points, but that’s actual cash flow, not just revenue, and it’s a pretty extraordinary growth number for a real estate investment trust (REIT).
The most important things for me on an operational front are that IIPR is still maintaining a high average return on invested capital in the new deals they’re signing, though that return is declining very gradually for the portfolio as a whole; and, at least as far as I can tell, that they have not yet run into problems with tenants who are in financial distress and can’t pay the rent.
They used to talk about the initial cash return being above 15%, it was 15.8% a year ago, and the latest return on invested capital average is now 14.8%, including the management fees they charge (1.5% of the capital invested, usually). The average lease term is actually growing a bit, so the portfolio average term is now over 15 years, and these deals all have annual rent increases as well.
So, as expected, their returns are dipping a bit as competition enters the market and marijuana growers begin to have more flexibility… the initial cap rate for their deals is probably 13% or so now, not 15% like it was a year or two ago… but they’re still pretty much the highest returns you’ll see in real estate, which is why they’re valued at more than twice the value of the investments they’ve made (they’ve invested a total of $200 million, plus they should have about $180 million in cash… the company is valued at $800 million, enterprise value is close to a billion with their convertible debt and preferred shares).
IIPR continues to walk that fine line in the pot industry, they have been able to raise pretty cheap capital as if they’re a fully “legal” company (partly because they’re listed in NY), and they can charge pot growers a lot for capital because there aren’t a lot of big competitors willing to finance marijuana projects (since, technically, those planting operations are still illegal and the big banks won’t touch them). That won’t last forever, they are seeing competition come from below as other small REITs and specialty finance companies try to get into the market… and as federal legislation moves in the direction of freeing up banks to participate in the marijuana market, they will likely also begin to see real competition from above, including the availability of commercial mortgages, which is probably when the returns will really begin deflating for new deals.
So they are losing some of their competitive edge, almost certainly… and that’s reflected in the gradual erosion of their returns, but they can give up a lot of their return and still have a really good business, particularly if they’re doing so at a time when their customers are actually seeing regulatory improvement and therefore becoming better tenants who are less of a credit risk. That’s not necessarily a straight line continuum, but that strikes me as the direction we’re going… IIPR is going to get lower returns, but they’re also going to get stronger customers and lower risk… and if their tenants become “bankable,” then IIPR could also lever up like other REITs, take on low-cost debt, and improve per-share returns that way. For a startup REIT, that point when you can lever up the portfolio by selling some bonds can sometimes really fuel some dramatic dividend increases… it might not be coming soon for IIPR, we’ll have to see how legalization progresses and how the capital markets feel about marijuana over the next year or two, but they also are growing their cash flow so fast that they don’t need help to raise the dividend yet.
As with The Trade Desk, IIPR is probably too large a part of my portfolio for me to add to it unless it’s ridiculously cheap… and that’s not the case here, there is certainly possible growth from this point, but the downside risk is also higher than it was when I last looked at the shares. I’m probably also psychologically anchored to my purchase price, and I have a hard time adjusting my view when the stock outruns my expectations this quickly, so that’s a challenge for several of these rapid growth stocks this spring.
When in doubt, evaluate a REIT based on its dividend and its dividend growth, because eventually investors will be buying because of the dividend and paying more for a growing dividend. The dividend is already covered by their funds from operations (FFO) at this point, though just barely as of this quarter (that in itself is pretty remarkable for a company that just started building its portfolio a couple years ago — again, a nice bonus because of the high lease rates), so I would be a little surprised if they raise it again immediately… but the growth is still rapid as their deals spool up and rent payments begin, so another dividend raise before the year is out is likely (they should declare the next dividend at some point over the next month or so, for payment in July).
I would be surprised if we don’t see at least another 25% raise in the dividend by the end of 2019, which would bring the dividend to $2.25 per share. I’d prefer to hold out for a 3% yield, which would be a $75 share price (based on that assumed future dividend), but there’s no guarantee we’ll get that. There is no analyst coverage to speak of, though my impression is that IIPR continues to be the most consistently teased pot stock by newsletters and the one most often mentioned as a “safer” exposure to pot in most of the financial press.
The leverage of their huge returns will really hit the cash available for distributions over time, so dividend growth could continue at a heady clip if they can get more of their cash invested before competition cuts too much into returns… and these are long term leases, so as long as their tenants don’t start going bankrupt they should be in good shape. That’s a fairly big “as long as,” particularly for a new industry in which profitability is lacking and we don’t really know what pricing and the supply/demand balance will look like next month, let alone in a few years, so that’s a risk… but I’ll still take IIPR as the only pot stock that lets me sleep well at night, and this quarter doesn’t change much. The stock is obviously trading on sentiment over any short period of time, like any “story” growth stock, but we get a growing dividend while we hope for a panic that might let us buy cheap.
What else caught my eye this week?
Intel (INTC) is scaring the heck out of people, mostly because they just slapped investors in the face with a wet dishrag in the form of their three year forecast… they said that revenues and earnings will both rise in the low-single-digits annually as they reinvest in the next wave of innovation and deal with the increased competition from other chipmakers who have been catching up. No one buys a tech stock because they’re hoping for three percent earnings growth, so Intel is now no longer appealing unless it drops to a large dividend yield… and Intel, as the largest company in the semiconductor space, tends to dominate the narrative about semiconductors in general.
Qualcomm (QCOM) declared its latest dividend, and it was bad news — they did not raise the dividend, and that’s a bit of a shock. They are still paying a decent dividend, 62 cents per share annualizes out to $2.48, so that’s a 2.8% yield (higher than Intel, FWIW)… but Qualcomm has been a dividend growth company since they paid their first dividend in 2003. Every year they’ve raised that payout, sometimes more than once a year, and they’ve never gone five quarters in a row without increasing the dividend. Until this week.
They didn’t say anything about the dividend on the conference call, and I haven’t seen any other commentary from the company about a change to their dividend policy, so unless I missed something we don’t know why they decided not to increase it this quarter… but they clearly know that they have increased the dividend every year for 16 years in a row, and they clearly decided not to continue that trend this quarter, despite the fact that they have ample cash and are expected to see earnings begin to grow again following their Apple settlement.
Qualcomm was a bit weak this week anyway, because of the continuing bluster of the “Trade War” (China is Qualcomm’s largest market, both because they sell a lot of chips into Chinese smart phones and because many other phones are also assembled in China). I haven’t done anything with this position this week, and I’m pretty much on hold for this one anyway as we await the FTC ruling, but the lack of a dividend raise deters me from a stock I’d otherwise be interested in adding to more over the longer term.
And as plenty of folks have noted in emails to me this week, fellow 5G “story” stock Nokia (NOK) continues to be awfully weak as well. There isn’t any “new news” of substance that I’m aware of, just pessimism piled on their disappointing earnings report of a couple weeks ago, perhaps juiced by the general trade war panic, and a bit of a sentiment shift away from the stock as investors begin to fear that Nokia is going to miss another growth market and fail to catch fire in 5G.
I think that’s likely just an overreaction, though, as I’ve noted before, with the huge focus on the second half of 2019 as the “this is when 5G will really roll out” period, and the growing obsession with whether or not the 5G equipment companies really hit the expected sales numbers late this year and in 2020, the risk is obviously high. If Nokia downgrades it’s guidance for the year because the second half turns out not to come in as strong as they’ve been anticipating, the stock could certainly fall further still.
I don’t think that’s likely, in the long term. I continue to think Nokia is among the better risk/reward stocks for 5G thanks to its huge market presence, reasonable valuation, and strong dividend (with dividend growth a management focus)… but I haven’t added to my position this week. They might have to actually report another quarter and again reiterate (or upgrade) their guidance to regain some investor trust at this point, so patience might be required, and in the meantime we’ll continue to see lots of scary language about lawsuits and how Nokia is a “broken” stock. The class action lawsuits will, I expect, amount to nothing — they almost always do, there’s no real indication of major legal trouble that I’ve seen, this is probably just lawyers fishing for clients like they do whenever a big stock goes down or disappoints… and Nokia can’t ride 5G momentum when there isn’t any and Intel and Trump’s trade tweets have sucked all the oxygen out of the room, so for another bump higher in the stock we’ll probably have to wait for either a return to 5G excitement in the markets, or some more confirmation that Nokia is actually going to book that revenue that we all expect later this year (or maybe both).
I’ll let you know if my assessment changes, this is a decent chance to build a position if you like the stock, and if you were using stop losses you would have already sold out… I’ve been adding gradually for six months now and I’m not in a rush to try to call the bottom, though I couldn’t resist buying a few LEAP options this week.
And here’s a new buy from the watchlist that I think makes some sense, though it’s likely to be a relatively short-term investment (a year or two, I’m guessing) — it probably isn’t well-managed enough to be a stock I want to hold for a long time.
Office Properties Income Trust (OPI) went on my watchlist a couple months ago because of its continuing disastrously bad performance. This is a stock that used to be fairly unique when it was called Government Properties Income Trust (GOV) — it owned buildings that were leased mostly to federal, state and municipal governments (mostly office buildings), and therefore its customers had great staying power and good credit and always paid their bills. Easy peasy.
Except it was a pretty terrible company, with outside management from the RMR Group (RMR) that got a reputation for taking advantage of the REITs they manage, and for years they paid out a much higher dividend than they could really afford, taking on too much debt to help cover the payouts, so the dividend never grew and investors sold the shares on any weak news because they didn’t trust the dividend, which often got up to a pretty staggering 10-12% yield.
That matters, partly because REITs are still a segment dominated by individual investors… once people lose faith in a story or a management team, it’s hard to get it back. And, it turns out, those who were worried about GOV were right — it was a disaster waiting to happen. And that disaster came in the form of shock reset for shareholders — a merger with Select Income REIT (SIR), another RMR-managed REIT that primarily does single tenant sale/leaseback or triple net deals, combined with a slashed dividend and a share consolidation. So they lost the “uniqueness” of the government properties portfolio that gave them their identity, lost the high dividend, and lost investor confidence… and folks who held the shares through that calamity saw their shares lose 60% of their value.
But even lousy companies can be attractively priced sometimes, particularly if they have the potential to go from bad to average… what are the odds there for OPI now, and is it worth the risk in order to get an above-average return from a real estate stock that owns pretty boring and what should be reasonably steady properties?
That’s a good question… and though what matters is the future, I start with the past: Government Properties Income Trust (GOV) and Select Income REIT (SIR) combined to create Office Properties Income Trust in a deal announced last fall and consummated on December 31. Before the deal was announced, GOV had a market cap of $1.67 billion and SIR $1.8 billion, and both had been falling pretty sharply in 2018 (while the REIT market in general was up a little bit)… neither of these was an investor favorite, though both paid high dividends (about 10% for both at the time the deal was announced).
Combined, then, you got two relatively small REITs who own mostly a variety of single-tenant office buildings, mostly of middling quality (no sexy landmarks in Manhattan or anything like that), with a market cap of about $3.5 billion and a 10% yield that was almost but not quite covered by cash flow.
What about now that they’re together? They slashed the dividend, decided to sell off a bunch of properties to deleverage ($750 million of sales targeted in the first six months, bringing their “Debt to Adjusted EBITDA” metric down to 6 or 6.5 or so, still pretty high but comparable to some other office REITs — they’re already most of the way to selling those properties), and consolidated the shares (1:4), and we end up with what is now a $1.3 billion company that has a 8%+ yield that the management team believes is very sustainable and sets them up for future growth once they’ve “right sized” the portfolio.
There might be something worthwhile there, right? More than two billion dollars of equity value just went up in smoke, and you’re not supposed to see a real estate portfolio, especially a pretty boring one, lose 2/3 of its value in six months.
GOV and SIR were not terribly appealing as individual companies, despite their high yields… GOV was particularly in trouble because of falling occupancy rates and a worrisome near-term lease expiration schedule, and that’s part of the reason they decided to merge.
But now, with the stock falling so far that it’s a high yielder again even after they cut the dividend by 2/3? Man, that’s tempting… these same buildings, other than a few that have been sold, were almost supporting a yield three times this size a year ago. Either an 8%+ yield or a “beaten down so far it can only go up” story might be worth considering at this point, and this might be both if they can actually get their act together. I think Investors have just traded this based on the dividend — cut the dividend by 68%, and the stock has fallen 60%, without much regard for the fact that the dividend is much more sustainable now and the company less levered and arguably less risky.
So did it OPI value just because of the dividend cut, or because investors got scared away by the bad management and the RMR connection? Or is there a better reason? Might they not get their act together? Will it keep drifting down further still, getting that yield up to 10% like GOV and SIR paid before? That would be one possible downside risk — all else being equal, if investors decide they need a 12% yield in order to make OPI worthwhile that would mean the stock has to fall to $18 (10% would be $22).
The big difference now, I think, is the reset to more reasonable sustainability. The point of this “reset” that they did with the merger was to give them cover to cut the dividend and diversify the portfolio (and, perhaps, to save a couple weak REITs so that the outside manager didn’t lose those management fees).
The dividend is now 55 cents per share per quarter, which should cost them about $108 million per year. Paying that shouldn’t be a problem… operationally things are a little bit worse than they were last year, they have seen occupancy drop from 93% a year ago to a hair below 90% on March 31, and their net cash operating income dropped a couple percent as well, but it’s still more than enough to cover the dividend. The biggest challenge seems to be occupancy, but the company is selling properties that are relatively low in occupancy and they say their leasing pipeline is strong, and that should serve to boost the overall average occupancy back up by at least a little bit — the CEO said “I think we’ll be above 90%” on the call.
So the current dividend should easily be covered by the operating performance. They’re not paying out more than 100% of FFO or AFFO any more like they did in recent years, they’re targeting 75% of “distributable cash,” which I would think is very similar to their AFFO numbers… and it’s not going to remain quite as levered as it was, since both SIR and GOV were a bit overextended and they’re in the process of selling off properties to reduce the debt burden… which will also improve cash flow.
The U.S. Government is still the biggest tenant, responsible for about 25% of revenue, and some state and other government tenants add another 10%, so about a third of the portfolio, on a rent basis, is now from the gummint. The sense I get from the conference call is that they’re selling properties that are not fully leased, or that are going to require a “refresh” or some substantial capital investment in the next few years.
General and administrative expenses are expected to come in around $32 million a year, all paid to or through RMR group, the outside manager, but that number is also based on the market cap… so it falls as the stock falls, particularly now that the market cap is a little below the book value of their equity in the property portfolio.
“Outside manager” is often a term of derision in some parts of the real estate investing world, and RMR is not a group that’s loved by the investors in the REITs they manage… they’ve generally not been the greatest stewards of investor capital in the various REITs they manage, but that does not necessarily have to be a deal breaker. That’s why I don’t expect to hold this stock for a long time, but I do think I can make a profit from it in the shorter term.
Office Properties Income Trust (OPI), like many other externally managed REITs, does not really have employees — they contract out to RMR to provide all the services they require, including the basic investor relations stuff (filing and accounting and all that) as well as the real estate operations, buying and selling property and providing property management and construction services. This isn’t just an “extra” management fee, it’s largely a management fee paid in lieu of actually paying for the REIT to have its own employees and management team. And OPI, like the other REITs managed by RMR, also owns shares of RMR (that fluctuating value hits their earnings too, which I mostly ignore).
RMR gets an incentive fee, too, if things go well — they haven’t lately for GOV, so they didn’t owe an incentive fee last year or the year before, but SIR did so they paid that along with the closing of the merger. I’ll be surprised if they owe an incentive fee to RMR given the weak performance so far this year, but it’s based on rolling longer-term stock performance so hopefully they’ll owe an incentive again at some point.
That big “reset” of the stock during the merger also provides a reset for the stock price, and gives RMR the chance to start over with this portfolio, I imagine (I don’t guess they have a “high water mark” for that incentive fee, but they might), and earn that incentive fee if they can get the stock price moving again… that hasn’t happened yet, obviously, but the incentive is there, and incentives do usually drive management behavior. The standard incentive fee RMR earns is 12% of the excess return over the benchmark index, which in this case is based on the SNL Office REIT index — it appears that the last time GOV owed that incentive fee was probably 2016, given their historical performance, and I imagine RMR would like to earn that again someday. If they do, it will mean the stock is doing pretty well.
In the end, I think that their sales of properties this year and their gradual deleveraging, which they expect will allow them to again begin growing in the second half of 2019 (gradually adding to their portfolio, sometimes by selling older buildings and buying new ones), should give them a chance to grow the dividend from the current level. That should help the stock price. Right now, the dividend yield is about twice that of the average equity office REIT, and the debt coverage ratio is about a third worse than average. I don’t love the management relationship with RMR, and I don’t think this is the best portfolio of properties… but neither is it the worst, and I think that with their strategic reshuffling and their strong dividend coverage and possible growth next year it is unlikely that we’d see the yield get a lot higher than 8% in this environment.
I think we’ve got a decent chance that the stock could recover to the mid-$30s over the next year or so, if investors begin to accept something closer to average like a 6% dividend yield that would mean a stock price of $36.50, so I’ve bought some at $26.50 and will collect the 8.3% yield while I wait to see how the story develops into the end of 2019 — if the stock dips much closer to $22, that could be a sign that I’m wrong… or that investors hate RMR even more than I think they do. I will probably not own these shares in 18 months, since I think we’ll get an indication well before then of whether I’m right or wrong in this assessment, but we’ll see how the story develops.
Sandstorm Gold (SAND) released its quarterly update, with no real news. They’ve continued to add some more significant royalties over the past year, which means their gold ounces production number should be rising a little more steadily than would have been predicted a year ago (when the production was mostly projected as flat until the Hod Maden project in Turkey begins producing), but Hod Maden is still the big differentiating factor — if it gets built and starts producing within the next four or five years, as Sandstorm expects, then Sandstorm Gold is foolishly underpriced unless the gold price falls (if the gold price falls, production doesn’t matter much and Sandstorm shares will fall… though they shouldn’t fall as much as the miners). If Hod Maden doesn’t get built, or takes another several years longer, then SAND is reasonably priced here for a flat gold price (at about 10X 2019 revenue, which over the past 20 years or so has been a reasonable floor for precious metals royalty companies… though sometimes they do fall through the floor when commodity prices collapse or one huge project gets derailed). Hod Maden provides the juice that makes this my favorite way to have levered exposure to gold without catastrophic risk (there is still plenty of risk, of course, and investors sometimes focus overly much on the political risk in Turkey, but as a diversified non-operator with no net debt SAND won’t go bankrupt if gold falls for a while… it will just go into hibernation).
And I noted earlier this week that I sold my ZAYO shares on the announcement of the deal being signed for a takeover, finally… but I also said I’d follow up with more of a look at the math of that decision, so here’s what I was thinking in more detail.
The Zayo (ZAYO) deal is finally done now, should we sell right away?
I see no real likelihood of a competing bid, which could have emerged a couple weeks ago but did not, so selling near the offer price seems to make the most sense. The deal will require regulatory approval and shareholder approvals and take some time, so in my mind, “when to sell” is mostly a question of the time value of the money.
If we assume it takes a year to close, which might be on the high end (they say “first half of 2020”), and that the deal does indeed go through as agreed at $35 cash per share, then it’s easy to sell at $35… but people aren’t likely to bid $35 for the shares unless rumors of a competing bid or dissident shareholder group emerge (neither seems likely to me, but I don’t have any inside information on the company or the industry).
Should se settle for $34? That leaves a dollar on the table for the merger arbitrage people to scoop up — and a dollar as a percentage of the money that’s at risk ($34 per share) is 2.9%, so that’s essentially what you earn for waiting and leaving your money at risk in ZAYO shares. That’s not enough to take the risk of holding, in my mind, that’s essentially the same as a risk-free return (a one-year CD offers 2.75% right now).
So that would be a pretty easy sell… But no one is offering $34 just yet. $33 and change is the current bid, $33.20 as I type — which is a return of $1.80 for your $33.20 at risk, and that’s a more appealing 5.4% return with relatively low risk… with rates where they are, and even junk bonds bid up to high prices, that’s better than you can get from a junk bond ETF and much better than you’d get from a portfolio of shorter-term bonds. You can see why merger arbitrage folks would happily lever that up, borrow at 3% and diversify across a bunch of deals and get a nice relatively uncorrelated (to the broad market) return to justify their fees.
But this is one deal, not a portfolio of merger arbitrage, and it’s not “no risk.” My guess would be that the odds of a failed or delayed transaction are higher than the odds of a surprise higher bid, so I’ll leave the extra 2-3% or so of additional return on the table (we can earn 2.75% with no risk, remember, and even 2% just by letting it sit in a money market account, so this is a game of competing choices) and walk away now.
I think the real determining factor, beyond your risk tolerance and whether or not you have something better to do with the money, is time, which means we’re splitting hairs a bit — if you can be sure the deal will close in February, then that becomes an 8% annualized yield… if it gets delayed for some reason and doesn’t close until later in 2020, it could be 4% annualized from this point. Still not bad, but not, I think, worth holding onto until the finish line… your decision framework, of course, might be different.
I went into this looking at the stock as being about 30% undervalued in February, with the thinking that it should close that value gap over the next two years thanks to REIT conversion, with a small chance that a takeover might mean that return comes in a few months instead of a couple years… then the takeover chatter heated up, and we get that valuation gap closed immediately and I’m selling the shares 28% higher (my return is lower than that, since I added to the position when the takeover looked more likely). It’s a bit odd that things work out so closely to the rumors, and fairly quickly, but we’ll take that as a nice quick win and all of a sudden we’ve got even more cash in the Real Money Portfolio. Part of that cash is what went into my new OPI position.
And that’s what’s happening with my portfolio this week — I’m mostly ignoring the trade war craziness. I certainly wouldn’t try to do any short-term trading around a political sentiment that’s jumping up and down, so I just assume that will settle down in the weeks to come and we’ll have something very different that the financial press thinks we should panic about next week, so now’s a good time to look at actual companies, what you think they’re worth, and whether that means the current price presents an opportunity. If you’ve got any ideas, feel free to share them with a comment below… and, of course, questions are also always welcome.
We’ll be back with more blather in the week to come — have a wonderful weekend!
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