Season Investments


Anything But Boring

Posted on January 26, 2016

“They want us to be boring for a while.” - Paul McDowell, Vereit’s Chief Operating Officer

2016-01-26_vereit.jpgToday’s Insight is the third post we’ve written on VEREIT (ticker: VER), a company we have owned for over a year in many of our client portfolios. We first wrote about this company, formerly known as American Realty Capital Trust (ticker: ARCP), back in November of 2014 amidst an accounting debacle that we felt was creating a unique opportunity for a contrarian investment. At the time, it was announced that a mistake had been made in the company’s first quarter filings resulting in earnings being overstated by 3 pennies. While this mistake was relatively minor and had resulted from an honest oversight, two of the company’s executives, upon discovering the error, decided that instead of reporting it they would simply make adjustments to the following quarters’ financials to cover it up. Upon the admission of these truths the company’s stock tanked and sold off to the tune of nearly 40%.

At the time we felt that this was an extreme overreaction to the news. While the actions of those executives were clearly illegal and needed to be dealt with, they didn’t materially change anything about the underlying fundamentals of the company. As we stated in our November 2014 post,

…this situation represents an extreme dislocation between price and fundamental value, thereby offering a compelling buying opportunity for a contrarian investor willing to ride out some intermediate-term volatility.

We initiated a position in the stock at just under $8/share the same day we published that original Insight, with the caveat that “any number of things could create another wave of negative sentiment that could send the stock even lower”. We then followed the investment up with a second post in March of 2015, updating our clients on everything that had transpired since making the original investment. At that time the investment was still working in our favor despite a number of additional negative developments. We felt confident that our original thesis of the stock price being overly depressed was being proven out by the steady climb upwards that we had seen up until that point.

Since that second post, however, the stock price has declined steadily bringing us back to roughly breakeven (inclusive of dividends) on our original investment. The chart below shows the path that we’ve taken over the past 15 months. Needless to say this investment has been anything but boring.


Since buying this stock in early November 2014 we have been in the green for 96% of the time, but now close to moving into the red. We are frustrated by the fact that we are now back to where we started on this investment. The goal of today’s post is to our thoughts on company’s current position and what we think the future will look like going forward.

What is clear to us, with the benefit of hindsight, is that despite the lack of materiality in the original accounting irregularity, the purported “scandal” became a sort of self-fulfilling prophecy. Financial statements had to be carefully audited and restated, which delayed corporate filings. Delayed filings caused the company to lose its investment grade rating and forced it to suspend its dividend. Cole Capital, its product distribution arm, was removed from platforms nationwide and forced to halt its capital raising activities until the dust settled. And of course, lawsuits and investigations formed a dark cloud of uncertainty that loomed over the entire company. None of these things had anything to do with the company’s core business of owning and managing commercial real estate, but they did have a real impact on the economics for shareholders of the company.

The sad truth is that all of this probably could have been avoided by simply disclosing and correcting the accounting mistake when it was discovered. The reality, however, is that the self-fulfilling prophecies created a number of real problems for incoming management to address. The most important development since our last writing has been the appointment of Glenn Rufrano as CEO. Mr. Rufrano has a stellar reputation in the real estate industry, and is known for being a turnaround specialist. After spending several months assessing the situation, he began taking proactive measures to set a new course for the company. These steps included a corporate name change, a complete restructuring of the board and executive leadership, and the reinstatement of the dividend.

But perhaps the most important thing Rufrano did was lay out a plan for the divestment of $1.8-2.2 billion in real estate assets. The point of these sales was two-fold. First of all, Rufrano felt that the company had far too much exposure to the restaurant industry via its portfolio of Red Lobster properties, and he felt by removing some of that concentrated exposure the quality of the real estate portfolio would be improved. The numbers seem to suggest this was a good idea. According to The Motley Fool, Red Lobster accounted for 12% of VEREIT’s rental income vs 7% for the largest tenant in competitor Realty Income’s portfolio.

Secondly, Rufrano believed that by trimming the real estate portfolio in this way VEREIT would once again be positioned to receive an investment grade rating. This is an incredibly important goal as the credit rating plays a key role in determining the future cost of debt capital (the lifeblood of any REIT). The key metric at play here is the Net Debt/EBITDA multiple which was sitting at around 7.5x for VEREIT when Rufrano took the helm. This measure comes in substantially higher than its peers who have multiples that are closer to 6x. Rufrano’s stated goal was to return this ratio to a range of 6.0-7.0 by the end of 2016, and with the successful disposition of $1.4 billion in assets in 2015 alone he seems to be well on his way.

One final note on Rufrano before we move on: we like the tone he is setting for the company. In a recent interview with the Wall Street Journal, he seemed positive and determined despite the lackluster performance in the stock as of late. In regards to making the hard choices and putting the company on a new path he simply stated, “I know what I’ve got to do.” And to the surprise of many analysts he even struck an ambitious tone by stating that by the end of the year the firm will “be able to present a plan for growth.” In a departure from the dramatic vibrato of his predecessor Nicholas Schorsch, Mr. Rufrano comes across as level-headed, honest and hyper-focused on execution while also showing strength and determination.

So where does this leave us? While our original thesis was right on some levels, we clearly underestimated the vicious cycle of negative sentiment that would keep the stock price depressed. And while it’s hard not to be emotionally-tied to the position, we need to remain open to the fact that the best course of action might be to cut ties and walk away.

That said, our current thinking is that staying the course on this holding is the best course of action. There are two primary reasons for this:

1)  The cheap valuation still implies significant upside.

At its current price VEREIT is trading at a multiple of adjusted funds from operations (a common measure of valuation for REITs) of roughly 9x. This represents a discount of around 40% to prevailing multiples seen for its peers such as Realty Income and National Retail Properties. This is quite cheap even after accounting for a slight decline in AFFO that is likely to occur on the back of asset dispositions. This discount adequately compensates us for the uncertainty surrounding this company, and it implies significant value could be unlocked if the company surprises to the upside.

2)  The attractive dividend pays us while we wait.

The current dividend yield on this stock is north of 7%, well above the yields of its publicly traded peers. What’s more, this dividend should be quite stable given the relatively low payout ratio of ~70%. If VEREIT does end up being a “value trap” (meaning the stock price stays depressed for longer than expected) we will at least be getting paid a healthy stream of income to wait.

In short, due to the bargain basement pricing we continue to believe that the risk/return profile on this investment is attractive. The downside from here should be limited given the amount of negativity that is priced in, and the potential upside is substantial if conditions improve more quickly than the market is expecting. In the meantime, we can lean on a stable dividend of 7%+ to pay us while we wait for the story to play out. Of course we will continue to monitor the fundamental performance of the company and the strategic execution of its management. Our goal is always be to maximize expected return per unit of risk in our client portfolios. This investment in particular has been a wilder ride than we would have expected, but then again we’ve never considered our job to be a boring one!

david_headshot_bw.jpgAuthor David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.

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Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.