Bad Habits Reappear At Wheeler Real Estate Investment Trust

| About: Wheeler Real (WHLR)


The preferred stock sales are increasing the financial leverage and replacing tax deductible interest with after tax preferred dividends.

Expansion is proceeding without a profitable history.

Distribution coverage now includes much more preferred stock dividend coverage. The company now has an additional roughly $6 million cash flow hurdle.

The dependence on BI-LO may increase the leverage risk. More customer diversification is indicated.

Capital appreciation prospects and sustained distribution coverage prospects have dimmed on this once promising speculation.

In so many ways, Wheeler Real Estate Investment Trust (NASDAQ:WHLR) got a second chance with a big infusion of institutional cash more than a year ago. But so many times, when management gets a second chance, it manages to recreate the mess that caused problems in the first place.

Click to enlarge

Source: Wheeler Real Estate Investment Trust, September, 2016 Investor Presentation

As shown in the slide above, the company delevered considerably by June only to begin selling preferred stock to increase the financial leverage again. More than $69 million of preferred stock has been sold during the third quarter. The slide above shows the considerable increase in preferred stock over the last few months. This happened two different ways. There was a September announcement of a class "D" offering, and there were references to the ATM sales of the other preferred stock from the shelf filing awhile back. Attempts to sell the "D" shares have been made periodically since the last acquisition, but have now evidently gained some traction. Much of the proceeds have gone to reduce debt incurred by the last massive purchase.

The company delevered by first converting the $93 million series
"C" preferred as agreed with the original institutional purchasers of the stock. Then an exchange offer followed for the remaining preferred resulting in the outstanding number of shares ballooning from an original 11 million to the nearly 74 million. A fairly small amount of the increase came from using tax advantaged units as part of some of the purchases. Those exchanges raised shareholders equity from $26 million to the current $113 million. Shareholders equity was actually higher except that an accounting charge for the dilution from the class "C" preferred holders conversion offset some of the shareholders equity increase.

The net effect of all this was a large increase in shareholders equity that more than offset the debt increase from more property purchases. The debt to shareholders equity on the slide dropped to more than 2:1 with a very small amount of preferred stock outstanding at the end of the second quarter.

Originally back in March 2015, there was only $26 million of common shareholders equity. So the debt to common shareholders equity ratio was about 6:1 before considering preferred stock obligations. Even before the series "C" stock there was at least an equal value of preferred stock outstanding when compared to the common shareholders equity. That is a lot of claims above the common units. Especially considering the lack of a profitability track record. Many investors would have considered the original debt ratios plain unacceptable.

Some of us thought that a "nothing down" purchase was not possible given the lack of an operating track record at the time. Well management came very close to that nothing down. But there was a price. Some of the debt would come due quickly and some was expensive. Management has been replacing that debt with preferred stock and selling more preferred stock to make potentially more acquisitions.

This new preferred stock is convertible and will limit unit appreciation until it is converted or redeemed. So all the long term holders that had slim hopes of the units appreciating back to $6 just had those remaining hopes crushed. Management had promised to not dilute the common units at the low prices existing during various conference calls, so that promise is kept so far. The cost of that promise is an overhang of new preferred shares converting at a slight premium to the current common unit price. But shareholders have to be disappointed with the latest events. The preferred claims are piling up again as the preferred sales proceed which endangers the common unit distribution.

In the process, deductible debt expense as been replaced by after tax dividends. While it is true that many things are flowing through to the unit holders, paying taxes on money used for preferred dividends is not a positive step. The return needed to make those dividends worthwhile may approach 15% before taxes. But this company has not demonstrated that kind of profitability ever. Losses have been the rule and a lack of distribution coverage the history.

Click to enlarge

Source: Wheeler Real Estate Investment Trust, September, 2016 Investor Presentation

As shown in the slides above, the company was finally on the road to covering its distribution for the first time when all that preferred stock was sold. This increases the cash flow goal of covering the common distribution considerably. The company now needs another roughly $6 million of cash flow to cover the preferred distribution in addition to the cash flow increase needed to cover the common units distribution as promised by the end of the year. The $40 million of 8.75% series "D" preferred will cost $3.5 million in dividends. The additional roughly $29 million of series "B" preferred will cost about $2.6 million in dividends. This is just from the sales listed above in the last three months on the slide. That is one very tall order for a company that has no track record of having enough cash flow for the common units. Plus some of the preferred stock is being sold under ATM conditions, so shareholders will need an update on the status of those sales and future plans.

While there are a lot of special charges and other non-repeating expenses that will decrease as the expansion pace slows down, management must still demonstrate that they can make the current financial set up work. The bankers are acutely aware of this and have insisted upon conservative debt to value ratios. Shareholders from the original IPO are probably fearing a repeat of history (another distribution cut).

Click to enlarge

Source: Wheeler Real Estate Investment Trust, September, 2016 Investor Presentation

As shown in the slides above, Wheeler management firmly believes that the steady traffic generated by the main customers make leveraging a reasonable strategy. However, the heavy reliance on BI-LO may make the strategy more risky than management currently projects. Customer diversification is key to reducing risk when leverage is used. So additional future customer diversification is indicated.

Cash flow is another area of concern. Management has pointed to two possible paths. First is to increase the occupancy rate of the properties owned. Many of the properties acquired have lower occupancies rates than the ones presently managed. Therefore a few percentage points increase in occupancy rates could significantly increase cash flow. However, occupancy rates are relatively high already so there is limited ability to increase the rates shown. Certainly there is not enough to increase cash flow by more than $1.75 million a quarter. Management will need to increase cash flow at least that much to support the increasing preferred dividends and the common unit distribution as promised.

There has been some increases in leasing rates at the time of renewals, however management clearly believes that upgrades and projects like shown above will lead to far more significant cash flow increases. But this pathway takes time, as only a small percentage of leases come up for renewal each year, and management has stated that the increasing lease rates only beat inflation by a little bit. So management has not yet demonstrated that this strategy will indeed work before embarking on the next round of acquisitions and expansion.

The preferred sales demonstrate the increasing costs of the higher activity levels to the common unit holders. Some time was needed to establish a convincing profitable track record of the units under management. Evidently this management is not going to pause long enough for that track record to be established.

Mr. Market has some very reasonable doubts. The market has been waiting for a verifiable track record of profitability that has never happened. Management has always responded with an enticing vision. But the land of opportunity and profits has never arrived for shareholders since the IPO. It is always just on the horizon.

But shareholders do have an ace up their sleeve. Institutional shareholders have seats on the board and enough votes to replace management. If management wanders too far from its original goal, then it probably will be replaced and the mess cleaned up. It would be far better though if management realized its limitations and accomplished long term goals a little more conventionally.

The loan to value ratio appears a bit low. Plus part of the last deal was not permanently financed. That led to some of the preferred stock proceeds replacing some of the temporary loans. Lenders may continue to be very conservative because of a lack of successful (profitable) operating history and a lack of adequate cash flow. Even with the collateral, this company is in danger of being cut off from debt markets by growing too quickly for the comfort of its lenders.

This is definitely not the ideal situation for common shareholders. The preferred shareholders are in a far better situation. The new convertible preferred may be the best investment vehicle for now. However, should the company continue growing without adequate cash flow or profits, then it may be time to completely abandon this once promising, but speculative, investment vehicle.

Disclaimer: I am not an investment advisor and this is not a recommendation to buy or sell a security. Investors are recommended to read all of the company's filings and press releases as well as do their own research to determine if the company fits their own investment objectives and risk portfolios.

Disclosure: I am/we are long WHLR.

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.