Tom Konrad CFA
On April 22nd, the court ruled against Power REIT (NYSE:PW) in the summary judgement phase of its litigation with Norfolk Southern Corp (NYSE:NSC) and Wheeling and Lake Erie Railroad (WLE). At issue were if NSC and WLE were in default on a lease of 112 miles of track, and a number of claims surrounding the lease, and if they owed Power REIT’s legal fees under the lease.
Had power REIT prevailed on any of a number of counts, it could have been worth as much as $15 dollars a share to Power REIT shareholders.
As it is, Power REIT still has the option to appeal, and there are a couple of claims against Power REIT which will need to be decided in a status conference scheduled by the court on April 29th, or at trial. These remaining claims regard whether Power REIT acted improperly when it reorganized itself into a holding company which owns its predecessor entity, the Pittsburgh & West Virginia Railway. According to David Lesser, Power REIT’s CEO, NSC and WLE have said in court that it is impossible to show financial harm because of these claims, and so I expect them to be settled or dropped at the at the status conference, unless Power REIT decides to appeal.
Grounds For Appeal?
I found the ruling shocking in that I did not expect much at all to be decided in summary judgement. While I thought many of Power REITs claims were weak, I thought others (such as default under the books and records clause of the lease, and the payment of legal fees) were quite strong. Another investor who has read the judgement told me he was “Truly shocked how one sided this went through, not that it matters but makes me wonder if [the] judge [was] corrupted or biased somehow.”
To me, the ruling seemed very biased as well, and I’m sure it seemed so to Lesser, judging from a short conversation with him. He felt the judge had gone far beyond the bounds of summary judgment, and was even creating new rights under the lease where none had existed before.
I don’t know if any of this constitutes grounds for appeal, but I am confident that if PW were to appeal, NSC and WLE would again fight the appeal vigorously, and the company could easily be left to pay even more legal bills than it has to now. Whatever the grounds, I don’t think such an appeal would be a cost-effective way to create value for shareholders.
Valuing the Remains
Due to a very timely note from another investor who had seen the ruling before I did, I was able to sell all of the client holdings of PW in accounts I manage, but I did not have time to sell my own before the stock fell below $8 and began to plummet. Shortly thereafter, trading was halted, and Power REIT made a press regarding the ruling.
When the market opens Thursday, the only remaining questions are if Power REIT will appeal, and what the stock worth now. Since I don’t think an appeal would be in shareholders’ interests, and Lesser is the largest shareholder, an appeal seems unlikely. Hence, I will focus on the remaining value. This ruling means that the company will be able to write off (for tax purposes) the $16.6 million value of a “Settlement Account” under the lease because the account is essentially un-collectible. This write-off allows the next $16.6 million worth of dividends on Power REIT’s common and Preferred stock to be taxed as return of capital rather than income.
The common stock does not currently pay a dividend, while the preferred stock pays a 7.75% annual dividend based on its $25 par value, or $1.875 per preferred share annually. Power REIT’s most recent shareholder update puts Funds From Operations (FFO) available to pay dividends on both classes of stock at $1.260 million annually (slide 18). $260 thousand of this is needed to pay annual dividends on $3.5 million of preferred stock, with the remaining $1 million available to pay the legal expenses which are the majority of the accounts payable at $1.260 million. Approximately five quarters of free cash flow will be needed for accounts payable before the dividend on the common stock can be resumed.
There are currently 1.7 million shares outstanding, which will probably grow as the company continues to pay stock based compensation. Let us assume conservatively that Power REIT resumes its dividend in late 2016, at which time it has 1.8 million common shares outstanding. Then FFO per share would be $0.56, easily sufficient to resume its former $0.40 annual dividend, while retaining significant capital to fund future growth. This dividend would now be categorized as return of capital, so shareholders would not have to pay taxes on it until they sold the stock, when it would be taxed as capital gains (usually at a much more favorable rate than income.) PW could choose to pay a higher dividend, but given its plans to rapidly expand its renewable energy holdings, I would expect it to retain some capital for growth. At any reasonable dividend rate, the tax write-off is large enough to ensure all dividends count as return of capital for well over a decade.
A 5-6% dividend yield seems reasonable for a tiny, but growing, REIT like PW, depending on how much investors value the tax advantages of the dividend and the growth prospects. A 6% yield would put PW $6.67 per share in late 2016, a 5% dividend would put the stock at $8 per share. Discounting that by 20% to account for the one to two year wait for the dividend to resume, I see the company’s shares to be worth between $5.30 and $6.70 per share.
There are a number of possible upsides to this estimate. On page 19 of the same investor presentation, the company valued its assets based on discount rates currently being paid on the open market for similar assets. The jewel in the crown is the railroad lease, which has similar cash flow characteristics as a perpetual bond from NSC. Valued at the 4% discount rate NSC pays on long term debt, the lease is worth $13.21 per share. At a more conservative 6% which I think PW might be able to get if it sold the lease to the highest bidder, it’s still worth $8.80 per share. Such a sale would do a lot to increase the current stock price by allowing Power REIT to repay its most expensive debt and/or pay legal bills and resume the dividend sooner.
The end of the litigation might also solve the problem of expensive debt by making banks more willing to provide financing with the perceived risks of the lawsuit are gone. Refinancing existing debt at a lower rate could immediately free up cash flow to reduce accounts payable and resume the dividend sooner, possibly at a higher rate.
Without the distraction of the lawsuit, Power REIT could continue the process of turning itself into a yieldco by buying land under solar and wind parks with mostly debt financing. Given the large tax advantages of its REIT structure combined with the return of capital treatment of its distributions for years to come, it might be able to resume and begin to grow its dividend much more quickly than I outlined above.
At $6.33 a share, where PW closed on the day of the summary judgment, the company falls within the range of fair value based on when I would expect it to resume its dividend. As the market adjusts to the new reality, look for buying opportunities below $5, or chances to sell if it quickly advances above $7 without news (such as a refinancing of debt) which has the potential to increase cash flow.
To me, the preferred stock, PW-PA seems like a much more attractive proposition. Power REIT has plenty of cash flow to continue paying the preferred dividend, and now that dividend will be categorized as return of capital for the foreseeable future. Even if the preferred dividend were to be suspended, it would have to be paid in arrears before the common dividend was resumed.
Disclosure: Long PW, PW.PR.A.
DISCLAIMER: Past performance is not a guarantee or a reliable indicator of future results. This article contains the current opinions of the author and such opinions are subject to change without notice. This article has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.