Why I Just Said "No" To O

| About: Realty Income (O)

Realty Income's (NYSE:O) $3 billion dollar planned acquisition of American Realty Capital (NASDAQ:ARCT) makes a lot of sense, a lot of sense for Realty Income shareholders, that is. As an ARCT shareholder, I just voted "no" on the planned merger and I encourage other retail owners to do the same. While I agree with ARCT management that the combined entity will be an attractive duo, my fellow shareholders are not receiving enough compensation to give up what is an appealing stand alone entity with attractive income generation and growth prospects in its own right.

At a price of $11.77, ARCT is being valued by O at a Price/FFO of about 15.5X and 13.9X FY '12 and '13 expectations. Realty Income is currently valued at about 20X and 17.2X '12 and '13 operating expectations. Further, with total equity of just over $1 billion and Price/book of about 1.8, ARCT currently trades at a lower liquidation valuation than Realty Income which trades at about a P/B of 2.2. These details are summarized in the chart below:

  '12 P/FFO '13 P/FFO P/Book Div. Yield
ARCT 15.5 13.8 1.8 6.07
O 20 17.2 2.2 4.51

Thomas Sandell of Sandell Asset Management in a recent letter to the ARCT board noted he feels the stand alone valuation of ARCT could be in the neighborhood of $13.50. If ARCT were trading closer in line with the valuation metrics currently given to Realty Income, I would agree that Sandell's price seems quite realistic.

As I mentioned above, there are certainly benefits to doing this transaction from ARCT's perspective. ARCT's concentration of top tenants becomes more diluted and its credit/cost of capital profile improves. However, ARCT brings plenty to the Realty Income table as well. As Sandell mentions in his letter and Realty Income in a letter to its shareholders, ARCT will be an FFO accretive transaction to O, with ARCT properties improving overall portfolio occupancy rate, lease duration, and tenant credit profile of the combined company.

In addition, Realty Income will be increasing the dividend rate to its shareholders should the deal close, while ARCT holders will be seeing a relative yield cut.

While I wouldn't have expected Realty Income to have valued ARCT as a direct peer, ARCT management should have demanded a higher valuation for its shareholders. For whatever reason, it appears they negotiated from a position of weakness instead of strength, as my perspective tells me ARCT is probably more valuable long-term to O than vice versa. Consequently, at the current deal price, shareholders are giving away too much and receiving too little. If I were a Realty Income shareholder, I'd be racing to vote yes on this deal, but as an ARCT shareholder I'm left feeling under compensated, yet still liking the idea of the merger.

I suspect in the end the deal will go through, as there doesn't seem to be enough chatter to derail it. The combined company will be successful, but I'll always wonder in the end if ARCT would have been more successful going it alone.

Disclosure: I am long ARCT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.