This article is going to focus on a very unique situation. That is, companies that are profitable, yet they do not pay a dividend to preferred shares. This analysis will look not only at the preferred stocks with suspended dividends, but also at the valuations of the related common stocks that trade in the market and how a suspended dividend to preferred shares may be affecting the valuations of those common stocks.
Fannie Mae and Freddie Mac
First, we will take a look at Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). In 2008, the Bush administration seized control of the two government-sponsored entities and used them to bail out the entire housing market. The company recorded large non-cash loss reserves and impairment of deferred tax assets. Meanwhile, they helped to stabilize the housing market by reworking and refinancing millions of loans at extraordinarily low interest rates.
By 2012, it was clear that Fannie Mae and Freddie Mac would not be booking the entire amount of their loss reserves, and that the companies would return to profitability and may recognize their billions of dollars in deferred tax assets. The shares of each company were bid up as investors placed a bet that they would be able to pay off their bailout to the federal government.
Then in August of 2012, the Treasury decided to change the bailout agreement to sweep 100 percent of all net worth for deficit reduction. As you may imagine, shareholders were not very happy about this. In fact, many have filed suits.
Now, what you have is a extremely profitable company with no capital. Treasury has also been paid back the entire amount of the bailout plus interest. However, because of the quasi-legal state of the conservatorship, and the uncertain future of the companies, there is no dividend being paid to either the preferred shares or common shares. This is a very unusual situation, especially considering that many community banks were told to buy the preferred shares "without limit" and not subject to "safety and soundness." In fact, these preferred shares carried the highest rating of creditworthiness at one point.
Today, the common stock of Fannie Mae trades at a forward P/E ratio of 0.68. Freddie Mac trades at a forward P/E ratio of 0.66. Without a doubt, the uncertainty regarding shareholders' future in both of the preferred and common stocks is limiting the valuation of the shares despite the profitable operations of both companies. In fact, many politicians seem to be fine with the fact that these companies appear to be in a perpetual conservatorship owned by the government, with no rights for shareholders.
First Bancorp (NYSE:FBP) is another company in this situation where preferred stock dividends are suspended, yet the company is profitable. Most of the company's preferred shares trade just above 50% of redemption value. The common stock of the company trades about a forward P/E ratio of 6.85, but the trailing P/E ratio is 1.58. (This low P/E number includes a large income tax benefit that was recorded in the income statement as part of the fiscal year 2014 results.) As a bank based out of Puerto Rico, some investors may be wary of investing in this company, especially after the recent failure of a bank like Doral Financial (NYSE:DRL) and the issues with the Puerto Rican debt and economy.
The total liquidation value of this non-cumulative perpetual preferred stock is $36.1 million, and these preferreds carry dividend rates between 7% and 8.35%. In 2014, the company issued 4.597 million shares of common stock to convert 1.077 million preferred shares into common shares. Investors who took that conversion offer would now have common stock shares worth about $12, if still held. However, throughout 2015, the common stock traded about twice the current level, and these investors would have been made whole.
Historically, actions like these typically precede a dividend reinstatement. Take a look at Royal Bank of Scotland (NYSE:RBS) after the financial crisis. The bank also tendered preferred stock at a discount, but shortly thereafter, reinstated the dividend. Another example is the National Bank of Greece (OTCPK:NBGIF), which converted its preferred stock to common shares. However, National Bank of Greece was not able to reinstate a dividend, and its future is now in question.
The annual dividend cost of these preferreds must not be more than $3 million. So, with the company reporting net income of $15 million in the most recent quarter, investors may question why management has not reinstated a dividend to these preferreds. Perhaps they see dark clouds in the future.
For Hovnanian Enterprises Inc. (NYSE:HOV), profits have been fleeting. In 2014, the company reported a profit of $1.85 per share, following a $0.19 per share profit in 2013. However, the company slipped back into losses in 2015. The good news is that revenue is expected to increase by 31% in 2016, and the company is also expected to report a profit, but the forward P/E ratio on the common stock is still just 3.27 times forward earnings.
As stated above, this article is focusing on preferred stocks with suspended dividends at companies that are profitable. In this case, Hovnanian has contractual restrictions on the ability to pay dividends to preferred (HOVNP) and common stock.
Per the company's most recent 10-K filing:
"In fiscal 2015, 2014 and 2013, we did not make any dividend payments on the Series A Preferred Stock as a result of covenant restrictions in our debt instruments. We anticipate that we will continue to be restricted from paying dividends, which are not cumulative, for the foreseeable future."
Once the company regains enough profitability to actually be able to pay dividends, you might expect the common stock valuation to recover to a market norm.
A final example is Impac Mortgage (NYSEMKT:IMH), which, in its latest 10-K filing shows $51.7 million in liquidation preference for outstanding preferred shares (IMPHO, IMPHP). For the year ended December 31, 2014, Impac reported a net loss of $6.3 million. However, in the first quarter of 2015, it made a major acquisition of CashCall Mortgage. Immediately, this deal improved operational results.
In fact, the company reported $56.8 million in operating earnings for the first nine months ended September 30, 2015 and total net earnings of $70 million for that same period. Total revenue for the first three quarters of 2015 was $131 million versus $32.7 million in the comparable period of 2014. This represents approximately a 300% increase in revenue. After subtracting out some one-time acquisition-related items, operating income on an adjusted basis was about $34 million for these first three quarters of 2015.
The company's common stock trades at a price to earnings ratio of 2.36. It should be noted this only includes three quarters of positive operating earnings from 2015.
At this point, the major overhangs with the stock valuation and reinstatement of preferred dividends are likely related to long-term debt, deferred tax assets, and consistent operational earnings. The company's long-term debt is still being carried at a discount to par value ($71.12 million par value versus carrying value of $31.6 million). At the start of 2015, the valuation allowance on the deferred tax asset was $163.2 million, and a tax benefit of $22.9 million has been recognized thus far in 2015. If this liability and this asset are written up to full value, the net positive effect will be possibly $100 million included in net income and added to the equity balance on the balance sheet.
Meanwhile the company's cash balance continues to improve, as it sold mortgage servicing rights to generate cash in 4th quarter 2015. It may have as much as $50 million in cash on hand.
With regard to the preferred stock dividends, the stated dividend rates amount to a dividend is about $4.7 million. Compare this to the adjusted operating earnings for the first three quarters of 2015, and you will see that a payment of dividends is sustainable to this preferred stock. By paying these preferred shares a dividend, Impac may unlock an additional equity market for itself. This should help the common stock valuation, as the company needs to grow further and will likely be tapping one of the equity markets soon.
There are only a few companies in this market with profitable operations and suspended dividends to their preferred stock shares. These are the five that are the easiest to find. If another company exists like this, please feel free to share. It is so unusual to see a company hold back on paying preferred stock dividends, especially since preferred shares tend to be a cheap source of capital to fund growth. Perhaps these companies will consider bringing their preferred shares out of default to unlock an additional capital market and increase the value of the common stock. Payment of dividends is the ultimate attestation to a company's financial strength
Disclosure: I am/we are long FMCC, IMH, FNMA.
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.
Additional disclosure: Long Preferred Shares of each company listed. Long IMH Common.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.