Submitted by Tyler Durden, publisher of Zero Hedge
There was a time on Wall Street when insider trading was rampant, when sellside analysts would pump stocks under the guidance of their superiors only to have their corporate finance colleagues do an equity offer shortly after, when the amount of money a bank’s corporate clients paid would determine its rating, and when analysts said in internal emails a company is worthless, only to issue reports claiming the company was the next sliced bread. Then things changed for the better briefly, when Spitzer came on the stage. However, with his thunderous fall from grace in an act of utter hypocrisy, the behavior he fought so hard to curb started gradually coming back.
There is, of course, nothing wrong with being a member of an underwriting syndicate – in fact, absent generating profits from AIG structured finance liquidations forever, banks like ML (better known these days as Bank of America’s slam dunk acquisition if one listens to Ken Lewis) will need it if they want to generate revenues. However, what Zero Hedge has a major problem with, is what ML equity research analyst Craig Schmidt did hours if not minutes after the offering was announced. In a research note update, Schmidt, who now gets his paycheck from Bank Of America (this will be relevant in a second), raised KIM’s rating from Underperform to Buy.
Write downs, not Q4 operating metrics, are the issue
KIM’s Q4 operating metrics took a back seat to write downs in the quarter as the company reported a sharp drop in FFO as it booked $111.8mn in non-cash impairment charges. These write-downs included $83.1mn for securities investments, $22.2mn for the equity investment in JVs with Prudential and $6.5mn for development projects in addition to $4mn of severance charges due to a reduction in headcount. While Kimco’s shopping center operations held up reasonably well in Q4 (rent spreads remained positive and same-store NOI was +1.4%), the company expects far weaker results in 2009 which is common theme running through the REIT industry.
Transaction income non-existent; lowering estimates
With the extensive write-downs, KIM’s reported 4Q08 FFO of $0.04 was $0.21 below our estimate. Looking to ’09, we expect NOI to decline 3% which includes a 300bp decline in vacancy by YE09. Given the impact of deteriorating operating metrics combined with a sharp reduction in transaction activity, we are reducing our ’09 FFO estimate from $2.15 to $1.74 while our ’10 estimate drops from $2.14 to $1.60.
Lowering PO to $12.50
Due to lower projected NOI growth for ‘09, we reduced our forward NAV for KIM from $17.04 to $14.13 and as a result our PO falls from $15.50 to $12.50 which is roughly a 10% discount to forward NAV. Given the weakness in retail spending and cautious leasing environment combined with a sharp erosion in Kimco’s noncore business segments we are maintaining our Underperform rating until we gain better visibility on the retail landscape.
Ah, good old circular conflicts of interest. To summarize: i) Merrill, which is probably not too happy with having lent out Kimco $707 million on its credit facility, underwrites a $720 (including a 15% overallotment) stock offering for which it gets $20 million, ii) Merrill’s analyst changes the stock from a Sell to a Buy, causing it to pop 30% in one day, and allegedly allowing participants in the offering to sell their shares at a 30% gain in a day, a mindblowing annualized return, iii) Kimco uses to proceeds to repay Merrill’s credit facility, cleaning out any credit risk exposure Merrill might have with respect to Kimco’s underperforming properties and operations.
At least Schmidt can sleep with a clean conscience after putting the following disclaimer in his report: “I, Craig Schmidt, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or view expressed in this research report.“
Zero Hedge, for one, hopes that Cuomo is reading Zero Hedge, as this kind of conflicted circularity would never have been allowed in the Spitzer days. Additionally, on a recent trip, this author stumbled upon a mall in a major metropolitan area where a Michael’s store (another LBO special) had recently vacated thousands of square feet of retail space: the beneficiary of this lack of future cash flow: Kimco Realty Corporation.
In conclusion – to those that managed to get in on the stock offering: congratulations. The 30% return in one day is nothing to sneeze at. To all those other retail and institutional accounts, who piggybacked, and all day were buying the shares sold by the follow-on participants (likely using Merrill’s brokerage desk as an intermediary, thereby generating even more profits for the company), hopefully you see something about the dreary mall REIT space that Zero Hedge is missing. Then again, as these purchasers are likely the very same people who are convinced that all the bad news in this market are lagging indicators, with all the seasonally adjusted “good” news are leading, the fair price of KIM to them is likely much, much higher. We hope they are right: in the meantime it never hurts to look at a cash flow or FFO model, and determine just how much cash a 38% equity-diluted KIM will be generating in the future as the bulk of its mall tenants either go bankrupt or decide they simply can not afford the rising rents that retail REIT operators hope to charge.
There have been comments concerning the sensationalizing of this event. I disagree with these allegations. My point here has been to point out that ML’s benefits from the Kimco affair are numerous, and to a large extent predicated upon the analyst’s rating:
– ML trading desk benefits from increased trading volume in the stock based on the report
– ML’s credit exposure is mitigated from a risky lender as the entire offering will go to pay down ML as a lender on the credit facility.
– ML’s corporate finance department generates a significant amount of revenue on successfully pre-selling the deal to equity investors who apriori only had the ML “Sell” report to fall back on.
Incidentally, a Credit Suisse report from March 12 (Neutral, $9.50 target price), repeats the very same concerns voiced in the earlier ML report. It also goes further to note that KIM needs to raise not $700 million but $300 million more for it to be viable in the long-run. I quote from the CS report:
The initial gameplan for this report was simple: We were going to write a report that would hit KIMCO’s value for the assets outside of core operating portfolio (33% of assets in the company Net Asset Value (NAV) and 27% of our gross assets estimate) and tell you to avoid it. We did exactly that, and still came up with an implied cap rate of 10.5%-one of the highest amongst a study set of trusts. And this is on a company with a management team that knows real estate, has bench strength, and did a lot to deleverage before things got too ugly-they just didn’t do enough.
The problem in our view is that the stock is too leveraged. At a 9% cap rate, we estimate KIMCO’s liabilities to assets leverage nears 70% with 27% of asset value outside of core operating real estate. The global REIT market seems to be applying going concern equity value to trusts with less than 60% leverage at 9% or higher cap rates-not a dumb assumption if this could potentially be the leverage level where conventional first mortgage lending might settle out. The cheapness of KIMCO also deflates when comparing its implied cap rate to its implied bond yield on credit default swap spreads. As a result, we believe KIMCO needs to reduce leverage to become an investable stock.
The trick to deleveraging is that you need to do enough of it. An incomplete offering like GGP’s ill-fated $822 million deal in March 2008 (and for that matter, KIMCO’s $408 million September 2008 offering) does not lead to outperformance. To that end, we estimate that to get to our 60% liabilities to assets goal, KIM needs to issue roughly $1 billion of equity.
Deleveraging can come from other sources: retained cashflow and asset sales come to mind. However, we have sat through too many presentations on how asset sales are on the way in global REITs only to see these transactions fall over at a later date. That being said, perhaps KIMCO can get to our magic 60% number with a combination of asset sales and equity-in other words, requiring less shocking dilution than implied by our $1 billion estimate.
Of course, ML may have had a perfectly innocent goal in mind when it upgraded KIM from a sell to a buy the day it did an equity offering. Whether or not that is the case is up to regulators to decide, if and when they analyze the specifics of the deal, having much more information than I have had access to. I will reiterate: the whole point of the post has been to highlight all the sides of the story, not merely what has been captured by the media or the report. ML could have avoided a lot of this hoopla by disclosing in its research report that it is the lead underwriter on the credit facility that is being repaid by the stock that it has just issued a Buy opinion on.
Another point: on March 25, another REIT AMB properties, on which ML also had a previous Sell rating, raised over $500 million in stock – ML was not a lead arranger on the credit facility but was a lead underwriter on the equity offering. Another ML analyst, Steve Sakwa raised the stock from a Sell to a Neutral (5 days after the offering mind you), not a Buy, on the offering. If the deleveraging thesis was indeed the critical issue here, does it not stand to reason that both stocks would have gotten the same rating (either neutral or a buy) based on the same catalyst?
Lastly the criminality was obviously framed as a question: to be a statement, many more facts need to come to light and hopefully in time they will. To unequivocally state that there are no conflicts between the research side of a bank and the other aspects of a bank’s operations would be to ignore the numerous discoveries unearthed in the Grubman scandals early in the decade.
Disclosure: no position in Kimco stock.