Crown Castle International Corp. (NYSE:CCI) recently hit the news after announcing an all cash $461M deal to acquire Tower Development Corp. (NYSE:TDC). The deal adds a further 300 wireless communication towers to the approximately 40,000 cell towers it already owns, operates, and leases. This makes CCI the largest provider of shared wireless infrastructure in the U.S.
This article focuses on CCI's 4.5% mandatory convertible preferred stock, Series A (CCI-A), and uses it as an example of how Convertible Preferred Stock can hurt your wallet if you don't do your homework.
CCI-A IPO'd with 8.5m shares @ $100/share on 10/22/2013. The proceeds of the IPO went towards the $4.85bn AT&T deal which gave CCI exclusive rights to operate and manage 9066 sites. The coupon is a cumulative $4.5, paid quarterly on 2/1, 5/1, 8/1 and 11/1. The 11/1/16 dividend will be the last one paid as on this date all preferred stock will convert to common stock. Conversion rates are based on the VWAP per share of common stock in the 20 consecutive trading days preceding the conversion date. Conversion rates are as follows -
if CCI <$74, CCI-A will convert at the rate of 1.3513
if CCI is between $74 and $92.50, CCI will convert at the rate of $100 divided by the market value of the common stock
if CCI >$92.50, CCI-A will convert at the rate of 1.0811
Some examples are shown in the table below:
It is perhaps worth adding that in 2014 CCI re-organized to qualify as a REIT for U.S. federal income tax purposes. This requires them to pay out distributions to holders of common stock, and has affected the tax rate of the preferred dividends, which now no longer qualify for the preferential 15% to 20% rate.
The problem with CCI-A
So far CCI-A looks like an OK buy. You will receive three dividends worth $3.375 and be converted into common stock at a rate that will give you $100 per share. This assumes that the common stock continues to trade at current value of $87.51 or at least below $92.50. Above $92.50 will net you a gain as illustrated by the table above.
The problem here is that CCI_A is trading at $107.94. After taking the dividends into account, the maximum it should trade at is $103.375.
My model to evaluate mandatory convertible stocks
A convertible preferred stock usually has a fixed dividend and a fixed term. The only unknown in the equation is the future price of the common stock. I use the internal rate of return calculation with static expectation for the common stock as a starting point.
Source: Author's own database.
This is the basic chart with the cash flows. Usually I would make a scenario analysis, but in this case the overvaluation is so obvious that there is no need. The present value of the cash flows generated by CCI-A with a static expectation for the price of the common stock and a 5% discount ratio is just $98.45. The static expectation IRR is negative at (-)4.15%. This is the most overvalued mandatory convertible preferred stock currently on the primary exchanges. The common stock will have to raise to nearly $98 so that a buyer at 107.85 gets his money back at the mandatory conversion date.
How I trade it.
I am short CCI-A. Hedging with the common stock is dangerous, because CCI-A cash flow will not change in the $74-$92.5 interval of the common stock's price. The risk of the trade is a very positive news that will drive the price of the common stock higher than $98. This risk can be hedged with a simple call option. The spreads are terrible on the 97.5 strike price, but this would be the most proper hedge in my opinion if you can get a nice fill.
There is one further risk and that is the author is missing something in the prospectus that gives some bonus payment to this stock. I highly doubt this scenario, but every one should read the prospectus carefully. The arbitrage is so obvious and I can not understand why the market is paying such premiums for easy to calculate instruments.
The author is wrong in this calculation and realized it the easy way by a comment from Brian Grad: "And indeed you have missed something huge. This preferred is dividend protected above zero and each quarterly dividend reduces the strike prices. The current strikes are 85.7707 and 68.6165. This makes the preferred in the money by over $2.00. Valuing it using 19% volatility makes it over 1.5 points theoretically cheap and this is the cheapest valuation this preferred has ever seen. It tracks on a .78 ratio so $5 of upside in the stock will move the preferred about $4.00."
Read every single detail in the prospectus, because it is always easier to lose money. Knowledge is not a guarantee for winning, but illusion of knowledge is a guarantee for losing as in my case with this particular stock.
Disclosure: I am/we are short CCI-A.
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.