PMC Commercial Trust (PCC) is a real estate investment trust (REIT) that specializes in loans to small businesses operating in the hospitality industry. Though the commercial real estate market and hospitality industries have been hurting (perhaps more than most other industries) due to the recession, PCC appears to have the makings of a compelling value opportunity due to the following:
- Safe asset base unlikely to be overvalued on the books
- Cyclically low earnings expected to rebound
- Shareholder-friendly management
- Dirt cheap valuation
Let’s discuss each of these in turn.
Balance Sheet: Solid Assets
The company originates loans under various Small Business Administration (SBA) programs, as well as outside the SBA via its own assessment of a borrower’s creditworthiness. The most important SBA program for PCC’s purposes is the SBA 7(a) program, whereby the SBA guarantees 75% of the loan, if certain eligibility requirements are met. Providing a maximum 25% loss for PCC.
For loans not covered by SBA programs, the company uses its own rules for extending credit. For example, PCC will only take the first lien on any property, and often demands personal guarantees of its borrowers. Further, PCC requires a minimum 20% down payment, translating to at most an 80% loan-to-value. In other words, if the borrower defaults and PCC forecloses on the building, PCC could take a 20% haircut (and wipe out the borrower personally, given the personal guarantees) on the sale, before it takes any losses. Additionally, over time since PCC does not allow its borrowers to “cash out” by refinancing at higher assessed values (one of the major contributors to the recent housing bubble), the loan-to-value ratio declines due both to increasing property values and declining loan balances, further reducing the likelihood of PCC taking a loss.
Given the above, I see little reason to believe PCC should trade for much less than its net asset value. Yet the company is currently trading for around $83 million despite (tangible) book value of $149.7 million. Why should PCC trade at just 55% of its book value? I will return to this question below.
Income Statement: Cyclical Lows With Little Downside
Approximately 73% of the company’s loans receivable are based on variable rates (LIBOR or Prime). The company notes that its net income is highly dependent on the interest rate spread between the rate at which it borrows funds and the rate at which it loans funds. Simply put, the company borrows at long-term fixed rates, and loans out at higher short-term variable rates. Since the company is currently operating in a low interest rate environment, its net interest income has been reduced dramatically. In the most recent quarter, the company had $184.7 million in variable rate loans versus just $77 million in variable rate debt.
From the company’s recent 10-Q (emphasis added):
Based on a sensitivity analysis of interest income and interest expense at June 30, 2011 and December 31, 2010, if the consolidated balance sheet were to remain constant and no actions were taken to alter the existing interest rate sensitivity, each hypothetical 25 basis point reduction in interest rates would reduce net income by approximately $269,000 and $242,000, respectively, on an annual basis. Since LIBOR has already been reduced to historically low levels, further significant negative impacts from lower LIBOR interest rates are not anticipated.
Thus, the company’s net interest income might reasonably be expected to increase in coming years as interest rates rise. In the meantime, it is unlikely that net interest income will decline any further. Though interest income is only one part of revenue, it has constituted an average of 73% of revenue for the last three years, so it is the most important element.
Governance: Forced to be Shareholder Friendly
PCC is structured as a REIT. This allows the company to avoid paying Federal income tax, but in order to maintain its REIT status, the company must distribute at least 90% of its taxable income to shareholders. There are few things better at focusing a management on shareholder returns than being forced to pay out 90% of taxable income. Shareholders have little reason to worry about many of the governance issues we see on this site, such as massive cash hoards that can grow indefinitely for little apparent reason [I’m looking at you Apple (NASDAQ:AAPL)] or else be wasted on ill-conceived acquisitions [I’m looking at you Microsoft (NASDAQ:MSFT)]. By forcing management to return most of its earnings to shareholders, there is little opportunity for waste. Over the last decade, the company has paid out $110.51 million, which is not bad considering the company has a market cap of just $83 million currently. Can you think of any (going concern) company that has returned more than its market cap in dividends without being forced to?
As noted above, the company is currently trading at just 55% of its book value. Why is this the case? Here are a few ideas:
- Companies trade at a discount to book when the assets are largely intangible, difficult to value, or of questionable quality. This is not the case here; 98.5% of the company’s loans are current and it has just $1.7 million of impaired loans net of reserves, but before expected recoveries.
- Companies trade at a discount to book value when they are losing money hand over fist, thus making it unlikely that shareholders will realize the liquidation value of the assets before management has eroded that value to a shadow of its current level. This is not the case here. The company has been consistently profitable, and not due solely to accruals; the company has earned positive cash flows from operations in 9 of the last 10 years, only dipping into the red this last year.
- Companies trade at a discount to book when management is not shareholder friendly, focusing on empire building over shareholder returns. This is not the case here; the company has to pay out the bulk of its earnings each year to maintain its REIT status.
Here is my best guess as to why the company is trading at such a discount to the value of its assets: as a REIT, PCC’s shareholders are driven by current yield, and investors worry that the company’s dividends are not sustainable. After all, dividends have exceeded cash flows from operations in each of the last four years. The company has essentially been in a very slow liquidation, generally collecting more principal (both scheduled repayments and pre-payments) than new loans funded. The difference between the two has largely gone toward dividends (this has been my interpretation of the company’s statements of cash flows, but if you think otherwise, let me know).
By funding a lower principal amount of new loans than principal collected, the company is essentially in a very slow liquidation, reducing the size of its retained loan portfolio and returning excess cash to shareholders. I have no problem with this, for two reasons. First, given the economy over the last three years, I would rather the company reduce its new loan originations instead of making poorer quality loans. Second, the company is returning the cash to shareholders, so how angry can you get with them?
Here’s how I see this: Unless you are a retiree depending on the current income from the dividend (a whopping 8.2% currently), it makes more sense to focus on what you are getting for your money. With PCC, you are getting $1.81 worth of loans and a free call option for every $1 you invest. A free call option? If the economy improves and the economy begins doing a more normal deal volume, earnings will increase and the shares will rise in value. If interest rates rise, the company’s earnings will increase and the shares will rise in value. If things carry on as they have been, the company will continue to retain fewer loans than the principal returned to it each year, and eventually the company will be completely liquidated (with you collecting $1.81 for every $1 invested, plus whatever the company earns in the meantime from premiums originating SBA 7(a) loans and servicing spreads). Not a bad deal. Hence, you get a free call option on any improvements, even though the company is cheap on its current situation alone. One thing to note is that the company expects new originations this year to improve over last year’s, signaling better times ahead.
Oh, one more interesting point before we’re done. In 2009, an activist investor, Bob Stetson of REIT Redux LP bought 4.5% of the company with the objective of pushing through change (either through reforming the operations or liquidating the company). Stetson went so far as to establishing a website to gain shareholder support and meeting with the company. He also took the case to the media. Unfortunately, it appears Stetson was unsuccessful and is currently throwing in the towel, recently announcing he had trimmed his stake by 104,655 shares to 3.52%. In the same filing, he announced he was no longer planning to engage in any actions that would have a material change on the company.
What do you think of PCC?
Disclosure: No position, but may initiate in the next 72 hours.