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Last July, I penned a piece on Trade Street Residential (NASDAQ:TSRE) wherein I suggested a potential liquidity event was looming for the residential REIT. This was a result of the company's crippling debt load, a large chunk of which was due last year, and the fact that the company's business model simply wasn't working. Shares were trading right around $8 when I made my call and after Wednesday's news, shares are once again above $8 after plummeting to $6 late last year. In light of new information received since I last visited TSRE, we'll take a look at the company's shares to see if enough has changed to warrant a long position or if it is business as usual at TSRE.
Back in July my bearish argument was based on two things: TSRE's business model wasn't working and the company had too much debt coming due to be able to continue on its current path. We'll tackle both of these issues and see if anything has changed at TSRE or if recent events are simply window dressing to make it appear the company is on a better footing than it was.
The Balance Sheet
As of the end of the third quarter, the last reported financials, the enormous amount of indebtedness TSRE was carrying in July was still present to the tune of $254 million. This figure also doesn't include the other ~$38 million of liabilities including interest and dividends payable. We must put this number into context and the best way to do that is in terms of the company's market cap. As of this writing TSRE has a market cap of only $92 million (prior to the dilution we'll discuss shortly). If you're keeping score at home, that means TSRE is carrying debt of more than 2.5 times its market cap. This is why I was suggesting either tremendous dilution or a liquidity event would fall upon the company last year and in fact, we've just seen one of those events happen.
TSRE announced on January 16 that it has completed its recapitalization which had originally sent shares flying from $6 to $7 after being announced in December. Prior to this event, shares had drifted down roughly 25% from my July article and I suspect it was because market participants knew something had to give. TSRE offered a total of 15.8 million shares in the secondary offering and another 9+ million shares in a private placement to Senator Investment Group LP. When factoring in TSRE's prior share count of 11.5 million, TSRE common shares, after the secondary, number around 36.4 million. Think about that for a moment; prior to the recapitalization TSRE had 11.5 million shares and subsequently offered more than twice that amount in a secondary. This is dilution on a scale I've never personally seen before and while a liquidity event has been avoided, consider the consequences for shareholders.
The press release states TSRE plans to use the proceeds to pay down debt and that is really the only thing it should be doing with that extra capital. As the accumulated losses on the balance sheet of $42+ million show, TSRE's business model doesn't provide anywhere near enough cash to pay down debt so the only real way to get rid of it is to dilute shareholders. The secondary offering netted proceeds of roughly $150 million to TSRE so assuming it uses that money to pay down debt and with shares trading around $8, we should see debt to market cap of about 0.33, a much more manageable figure than the 2.5 prior to the recapitalization.
While I don't debate the merits of the secondary offering for the company, as it is basically receiving free money to pay down its enormous debt load, I question why anyone would want to own shares in a company that would produce a secondary offering that was more than two times the size of the then-current shares outstanding. We'll take a look later at other consequences of the dilution and what it means for shares.
The Income Statement
If we turn our attention to the income statement from the first three quarters of 2013, the picture isn't any better than it was when I first wrote about TSRE last July. For the nine months ended September 30, 2013, TSRE reported total revenue of $19.75 million and an operating loss of $5.73 million. This represents operating margins of negative 29%! This is extraordinary unprofitability and you can see why I suggested TSRE would never be able to pay down its debt from earnings and why it was basically forced to commit to an enormous dilution of existing shareholders instead. The really alarming part of this is that the $5.73 million loss doesn't include $6.1 million of interest expense in that period. Consider that interest expense in the first three quarters of last year alone ate up 31% of total revenues and you'll see why I don't think TSRE has a workable business model. Granted, that should get better following the secondary offering because TSRE should pay down much of that debt. However, the cost will show up for shareholders as we'll see later and besides that, even with zero interest expense the company is hopelessly unprofitable.
In short, I still don't think the business model works because even if you assume every penny of debt will be paid back (which is currently impossible), the company still has horrendous operating margins that are very far below zero. And while the balance sheet will look much cleaner following the secondary, the fact is the company's business model is broken and I don't see much changing that. The result will likely be more operating losses and huge dilution in the future; the company cannot afford the debt it has and so the only way to raise capital is to dilute common shareholders or issue more preferreds, which are essentially just debt anyway. Either way you slice it, the picture isn't pretty.
TSRE currently pays a 9.5 cent quarterly dividend and at the recent price of $8.06, yields 4.7%. This is a decent yield but you can certainly do better in the REIT space without trying very hard. In TSRE's defense it is a relatively new REIT and particularly since it only went public last year. However, the point stands that you can do better if you're reaching for yield. In addition, some of the same problems I wrote about last summer are still present with TSRE and even a new one that has popped up.
First, the company still has the same problem of not being able to produce enough cash to pay its bills or its dividend. In the first nine months of last year, the company produced an operating cash flow loss of $1.6 million. Keep in mind that operating cash flows don't take into account dividend payments so as a proxy for how well the business is able to sustain the company's finances, operating cash flow is a good choice. With sustained negative operating cash flow the only ways to continue to keep the lights on indefinitely is to take on more debt, sell assets or issue more equity. We know TSRE has been paying down its debt and it sells assets as a part of its apartment "flipping" business model (explained in my article linked above), so the only thing left is equity issuance. We also already know TRSE did just that and issued an enormous number of new shares so what does that mean for the dividend?
The secondary is great for raising capital and the company can use it to decrease its reliance on debt, which should improve net income and cash generation via lower interest expense. However, with a company that pays a dividend it is a big negative. Consider that TSRE was paying 38 cents annually prior to the secondary on the company's 11.5 million shares; this implies an annual dividend payment of $4.37 million. While TSRE can't cover this with earnings or even cash flow, it was a somewhat manageable figure given the REIT's size. However, the secondary that just took place has sent the number of shares outstanding skyrocketing to 36.4 million; that same 38 cent annual dividend will now cost TSRE $13.83 million, an enormous sum given what we've discussed about the company's ability to earn and produce cash flow. The point is that something will have to give with the dividend; either it will be cut or the company will need to find other creative ways to raise money to pay it.
TSRE is a young REIT that is struggling to break even and produce enough cash to fulfill its obligations. The secondary offering will sure up the balance sheet and allow the company to dig out from its ample debt load but in the end, it is a negative for common shareholders in my view. Not only are any future earnings (if that ever happens) going to be split up between 36+ million shares instead of 11+ million, but now the dividend is a totally unsustainable amount the company has no hope of being able to afford. I think the result is more debt issuance that will fund the dividend or, more likely, even further common stock dilution. Neither of those are good outcomes as TSRE has proven the inability to make any money whatsoever and more dilution just exacerbates the problems I've raised here. Either way, I'm staying away from TSRE as it is overvalued and will likely see more negative catalysts on the horizon.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.