Thursday, May 13, 2010

Forced Dividends

Sometimes a company will appear cheap, but whether the investor will ever see the benefit of the company's success is another story. If management controls the company, or shareholders are not well represented on the board, the company could hoard money, or spend it on empire-building acquisitions. But some companies are organized such that substantial payouts are required.

Consider PMC Commercial Trust (PCC), a real-estate investment trust (REIT). As a REIT (rather than a regular corporation), the company must pay out at least 90% of its annual income. In doing so, it is not taxed at the company level. Large tax savings can generate significant shareholder value, as we've seen with both Dorel and Key Tronic.

With PMC trading at just $85 million, however, that value may be up for grabs for current shareholders. The company's distribution currently yields 8% (though this may decline with lower earnings), but that's not even the most attractive aspect of this investment: shareholder equity is over $150 million.

The company's assets are mostly in the form of loans receivable from franchised hotel owner/operators. These assets are secured by real-estate and personal guarantees. Earnings are depressed because interest rates are low (and so the company cannot earn great returns on its assets) and because economic conditions have made it difficult for borrowers to pay their loans.

To the first point, temporary earnings shortfalls should not drive the investment decisions of value investors. This is precisely the type of situation that leads to depressed stock prices, allowing value investors to profit in the long term. To the second point, PMC has been a rather conservative lender, and as a result has suffered few loan losses. The company requires significant equity investments on the part of the borrower before a loan is made, and does not offer any riskier loan packages including interest-only or subordinated debt. As a result, its satisfactory loans (i.e. loans that are not delinquent, or aren't on any watch-list for being behind on tax or franchisee payments) comprise 92% of its loan portfolio, up from 89% one quarter ago.

As such, at its current price, PMC may offer investors both decent income and the potential for capital appreciation due to the large discount at which the stock trades relative to its loan portfolio. Companies in similar lines of business with similar discounts to PMC that we've already looked at include Quest Capital and Manhattan Bridge.

Disclosure: Author has a long position in shares of PCC


Simon's Thoughts In London Fall '07 said...

Great points, I had prepared my personal "conviction buy list" which included this company. Most of my findings were based on the same ideas you highlighted.

One question I had for you though, I have been finding it to be increasingly difficult to value banks or lending companies for various changes in GAAP rules etc. What sorts of criteria do you employ to analyze these types of companies?

Keep up the fantastic work.


Ajay Kumar Konda said...

Prospect Capital (NASDAQ:PSEC) has 15% yield. Is it also a good investment?

Turar said...

Thanks for your post! Just started reading your blog recently, it's great.

I'm not sure about this one though, top line is steadily decreasing for the past several years, not just a couple of years.


Saj Karsan said...

Hi Simon,

Which GAAP changes do you refer to specifically? Anyways, I find it quite difficult to value most lending institutions...more thoughts on that here:

Hi Ajay,

I just glanced at it, but it appears to trade at a premium (rather than at a large discount) to its loan portfolio.

Paul said...

For those that may be interested, the financial results were released.

Anonymous said...

Hi Saj,

What do you feel about the merger announcement between CIM and PCC?

The $5.50 special dividend sounds great but less so for CDN investors especially if it subtracts from the current price.

The final merger price seems unknown and the current premium is not that much over the pre-announcement price.

The post merger dividend announced is not that much either but should hopefully grow.

Is it worth holding through the uncertainty?


Saj Karsan said...

Hi Anon,

I don't really know. My inclination would be to sell, because I believe I would be at a disadvantage to all the merger arbitrage players seeking to profit on any mispricing.