Short O, Long ARCP

Similar asset portfolios trading at very different multiples.  O trades at dividend yield of 5.3%, while ARCP trades at 8.3%.  This is almost as wide as it has ever traded.  The premium seems unwarranted:

• Same line of business –triple-net lease REIT
• Similar customer concentration
• Similar financial metrics
• Both barely cover their dividend
• Both highly leveraged

*Pricing as of Sept 5, 2014

I am not going to say that O should not trade at a premium to ARCP.  O is a much cleaner story.  It also has slightly less financial leverage than ARCP.  And, it covers its dividend by a slightly higher margin.  A premium is warranted, but not 300bp of dividend yield.  In my opinion, and for the reasons outlined below, the discount should probably revert to the 100 to 200bp observed during 2013 and 1H14.  Further, it should meaningfully contract over time as the ARCP story gets cleaner and leverage levels converge.

O and ARCP have been discussed on VIC before.  ARCP is seemingly universally hated due to actions of past management.  There are a lot of moving parts; making the story complex and harder to model.  ARCP achieved scale through a hasty agglomeration of real estate portfolios, financed through debt, preferred, and common stock.  The company has never shown clean, steady-state financials.  However, a lot has recently changed; mostly for the better:

• New CEO.  Replacing old CEO, who wasn’t exactly well-regarded by the market.
• Now internally managed.  Numerous, value-extracting fees gone.
• Scale.  Largest, diversified, triple-net REIT
• Focused.  Divesting all non-triple net, stand-alone building operations; including multi-tenant assets and broker-dealer.
• Long-term leases.  Majority with rent escalators; mostly high quality tenants.
• Fee income.  In addition to operating a diverse portfolio of core real estate investments, ARCP is responsible for managing, identifying and making acquisitions and investments on behalf of a few non-traded REITs’.

O has little room for improvement.  It is fully optimized.  It has lowered its cost of capital as much as possible.  Its debt maturities have been pushed out and are nicely scattered.  It probably can’t meaningfully improve its tenant diversification.  It has scale –and therefore not an acquisition target.  It has already been included in relevant stock market indices.  And it does not seem to have room to meaningfully increase its dividend, which explains why it feels the need to tout 0.1% dividend increases.

On the other hand, ARCP has a number of easy levers to pull to be in a much stronger position.  All indications point to a story that is getting cleaner.  Once the announced divestiture transactions at ARCP close over the next few months, the company will have only triple-net lease operations.  Thus, on this front, the situation has been alleviated of this concern.  The new CEO has made it clear that doing so is a priority.  He has also stressed the importance of reducing leverage to a more sustainable level.  For some time now, including his tenure as president, his message and actions are consistent with these objectives.  Further, his incentives are aligned with the interests of common stock holders.  In particular, his promotion (to CEO from President) incentives are in the form of $8 million worth of common stock (vested and unvested).  Further, he is buying an additional $1 million worth of common.

There is still work to be done with respect to financial leverage at ARCP.  There are multiple levers available to the company.  This, in my opinion, is the acid test that it will have to pass.  It seems to me that portfolio management actions in combination with opportunistic refinancing should be the way forward.  In the mean time, it is worth noting that ARCP is investment grade.  Most of its debt is low-cost, unsecured, fixed-rate debt with extended maturities (2017+).

From my perspective, dilution is the main risk here.  That is, the risk of dilution at ARCP beyond dilution at O; a serial stock issuer.  Nonetheless, with ARCP in the penalty box, any dilution at ARCP is likely to come with a much more violent reaction than dilution at O.  Seemingly, ARCP’s management is well aware of this situation.  On top of that, Mercato Capital –an activist fund with a strong reputation- chided ARCP for issuing common earlier this year.  Lastly, it is probably obvious to ARCP’s management that issuing common at these levels hinders the company’s ability to cover its dividend.  Further, given the size of ARCP’s portfolio, in all likelihood there are at least a billion dollars worth of accretive portfolio divestitures.

Red Lobster is ARCP’s single largest tenant; accounting for approximately 11% of the rental portfolio.  This adds a singular source of risk.  However, there are a number of factors that attenuate this risk.  First, the private equity sponsor that recently completed the acquisition of Red Lobster (op co) has substantial experience in restaurant business.  Thus, there is a fresh equity cushion of smart money under these assets.  The leases are cross-collateralized among pools of assets.  Most assets are new or recently remodeled, and easy to repurpose (according to management).

On the more positive side, ARCP has a growing, high-return fee income business with decent scale.  ARCP acquires (for a 1% fee) and manages (for a 50bp mgmt fee plus performance incentive fees) a $7b portfolio of non-traded REITs.  These fees are net to ARCP, and represent half of the total fees incurred by the managed vehicles.  The other half belongs to the entity responsible for raising the capital.  This structure provides a nice incentive to the capital raising company to grow AUM, without adding balance sheet risk to ARCP.  The expectation is for this business to generate $800 million in fees over the next five years.

In my view, management’s actions, incentives, and stated plans at ARCP point to operating convergence with O.  ARCP seems to be at the beginning of a new phase in its history, transitioning from a phase of acquisition-driven hyper-growth to a steady-state business.

Other than outright negligence at ARCP, it is hard to envision a scenario where trading yields continue to diverge.  If the macro environment continues to be positive, then there should be relatively smooth sailing towards convergence.  If asset values compress, then the sheer absolute numbers should somewhat cap the trading yield of ARCP.

This brings me to the catalyst.  While O has shown resilience in the past, its current fully optimized position leave little room for improvement.  In other words, it is very unlikely that it will be able to further lower its cost of debt or to meaningfully increase tenant quality and diversification.  On the other hand, in my opinion, the market is likely to react favorably to a cleaner set of ARCP financials (at least something that makes it easier to model) or accretive debt reduction.  It would make sense for ARCP to undertake a few portfolio actions in the last few months of 2014, and start 2015 with a clean slate.

In my view, operating convergence should become evident over the next twelve months or sooner.