Wednesday, September 7, 2011

M/I: Whatever You Prefer

It's not often that preferred shares are discussed on this site. For one thing, there aren't as many preferred securities nowadays. Furthermore, this site tends to focus on established, profitable small-caps and/or companies with low debt-levels; preferred shares don't have much use among these kinds of firms, and therefore such shares are not encountered often. There is an exception to this in the form of the publicly traded preferred shares of M/I Homes (MHO-A), a company whose common equity was discussed on this site last week.

You may not believe in the value of M/I Homes' common equity, which trades at $130 million despite having a book value of $185 million. But preferred equity shareholders get a higher priority over common shareholders, so that even if common shareholders lose money at this price or even get wiped out, you can still profit as a preferred equity holder.

The preferred shares receive a 9.75% dividend, and must be redeemed at $25/share. Currently, they trade at just $14/share. As such, if redemptions do take place (and the company is free to do so in 2012), preferred shareholders will see strong returns.

Unfortunately, there are some caveats which may actually make these shares undesirable, despite their massive discount. First, the dividend is not cumulative. Therefore, the company doesn't really have to pay it, and hasn't for several years now. The company would likely have to start paying it again if it ever wanted to pay something to common shareholders, but there's no reason to think that likely anytime soon. As discussed previously, the company appears bent on expanding; as such, it has cash requirements as opposed to excess cash that it is free to distribute.

Furthermore, there's no obligation on the part of the company to ever redeem these shares. So even if the company weathers this economic storm and emerges as a much healthier company in several years, it may decide that it wants to keep growing rather than redeem. The longer the company takes to redeem preferred shareholders, the less attractive the returns.

Preferred shares trading at major discounts to par can be terrific value opportunities. Investors must be sure to understand the securities' nuances, however, to ensure they know what they are getting into. M/I appears to hold a lot of the cards over pref shareholders in this case.

Disclosure: No position

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