Estimating a REIT's earnings is fairly straightforward. A REIT isn't a very dynamic business. Properties are traded and leased. Leases are usually very straightforward and don't vary much, and the sale or acquisition of properties is always evident through news outlets or corporate press releases. That being said, sometimes there are factors at play that make estimating the earnings a bit trickier.
In VEREIT's (NYSE:VER) case, the situation is a pending lawsuit as a result of previous misrepresentation of financial statements. I am positive that almost everyone reading this knows what I am talking about so I will only discuss the lawsuit briefly and will instead focus more on the AFFO impact that this could have on the upcoming earnings report. Still, after taking this in to account, I think we're looking at a modest AFFO beat of 1 to 2 cents a share. At the very least, I suspect management to report a penny above the Wall Street consensus of $0.17 cents a share when it reports on Thursday. Whether the company reports $0.18 cents or $0.19 cents depends on how high the litigation costs will be.
First things first
Before I start talking about the size of the litigation cost, it is perhaps wiser to start with estimating the revenue, work my way down to AFFO and then adjust for litigation costs.
The 3Q16 REIT revenue came in at $332 million and Cole Capital revenue was reported at $31 million. The REIT revenue needs to be adjusted for certain dispositions and acquisition. VER sold $394.9 million of properties at an average cap rate of 6.8% and acquired $100.2 million of properties at an average cap rate of 6.8%. In other words, the REIT segment declined by 1.88%. Based on my calculations we can expect the REIT AFFO to decline by that same amount, which means that the AFFO works out to be 0.185 cents a share or 19 cents a share rounded up.
This method may seem a bit rough around the edges, but we can check its accuracy by applying the same method in 3Q16. The REIT segment decreased to roughly $15.7 billion from $17 billion, or 8.5% from Q2 to Q3. As a result the REIT revenue decreased 7.7%. So there is actually a positive delta here, which makes our revenue decline estimate a bit aggressive. I don't mind doing this, because it makes the overall estimate more conservative, which in turn provides a margin of error on my beat prediction.
The second stream of AFFO comes from Cole Capital, a subsidiary owned by VER. In 3Q16 this segment generated about 2 cents worth of AFFO for investors. The caveat here is that some of this was due to a one-time tax benefit, so I'll be adjusting for this. Cole Capital generated $15.7 million in AFFO for shareholders, of which approximately half was due to the one-time benefit. In other words, I'm expecting Cole Capital to contribute one penny instead of two pennies in AFFO in the upcoming quarter.
Now that we have our base case of $0.20 cents a share from AFFO we can start adjusting for the cost of litigation costs. Before the company was named VEREIT, it was named American Realty Capital Properties and was managed by its founder. The company reported amazing results, but these results turned out to be influenced by falsified financial statements. Vanguard is currently suing former company executives and the company. Read more about it here.
The company has already spent $13.4 million in litigation costs and has guided for $35 million in total gross lawsuit-associated costs. The $35 million guidance actually represents a downward adjustment from the previously guided $40 million. In other words, management is expecting to incur $21.6 million in additional legal costs in the fourth quarter.
The reason that most of the costs seem to be loaded in the fourth quarter is that discovery is expected to start. Discovery is a notoriously expensive part of litigation and is a procedure created so that both parties can obtain evidence. The parties have several options to obtain evidence: requests for answers to interrogatories, request for production of documents, request for admission and depositions.
If you've ever watched any kind of law television drama you've probably heard the phrase "We'll bury you in paperwork and costs if you sue us." That happens in this phase.
When thinking of costs you should consider standard costs like paying your lawyer to do the actual discovery and gather evidence in favor of you. The biggest negative is that wealthy parties can increase the workload of your law firm. The increased workload naturally results in a higher bill. It is thus the defensive process - complying with expensive requests that your opposition is making - that is the most costly and labor intensive.
This is so much so that this part of the procedure has been criticized for favoring the wealthier side too much. This creates situations wherein smaller firms will not represent a relatively small party that is attempting to sue a corporate giant, even though the smaller party might have a very solid case.
From The Importance of Litigant Wealth (highlights from author):
"Plaintiffs who do bring suit may find that that wealthier defendants can exploit their resource advantage through various mechanisms - such as prolonged discovery - to prevail or resolve the dispute on favorable terms."
In any case, this explains why the costs will be ramping up significantly. The company is guiding to spend almost double of what they spent in the previous three quarters combined. Although I must say that I am a bit skeptical of the huge increase. I think the costs will probably be around $14 million and that management's guidance simply reflects their conservative attitude.
I'm not the only one who thinks that. Here's an analyst inquiring about the legal costs on the conference call:
"Anthony Paolone - JPMorgan: If I look at your legal costs that you guided to for the full-year it seems like that loads a lot into the fourth quarter. Is that a timing matter or is the run rate as we start to look into next year going to just the higher I guess as you are in discovery and there are a couple charges made?
Michael Bartolotta - CFO: We haven't given guidance for next year yet, but obviously we're anticipating an uptick in this next fourth quarter as we proceed through different stage.
Glenn Rufrano - CEO: When we give guidance which will be on the fourth quarter call, Tony we will give this as part of it.
Anthony Paolone - JPMorgan: So there is a legitimate ramp at some level here happening.
Glenn Rufrano - CEO: Yes. And it's in part as I did discuss and the litigation section discoveries beginning now and the judge has put a date on it in December at which the parties will provide discovery and that has caused a bit of a ramp up in this quarter."
The analyst is clearly surprised by the jump in legal expenses. However, Glenn (CEO) refers to it as "a bit" of a ramp up. I obviously shouldn't read too much in to this, but a bit isn't really the same as nearly double, now is it? This adds to my belief that he is conservative. Later in this article I will be providing some more proof to support this belief.
To sum this part up, management is expecting 2 cents in litigation costs, and I am expecting 1 cent in litigation costs. If management's guidance of 2 cents a share turns out to be accurate, we're looking at an AFFO of $0.18 cents a share, which is a beat by a penny. If my estimate turns out to be right, we're looking at $0.19 cents a share in AFFO.
So why is the guidance so low?
You might be wondering why management's guidance of $0.15 to $0.18 is so low given that their REIT segment produces roughly 19 cents a share. If so, you're not the only one. Consider this conversation between Glenn Rufrano and Christopher Lucas (analyst) on the 3Q16 conference call (highlights by author):
"Christopher Lucas - Capital One Securities, Inc.: Okay. But again I guess the low end just seems to be very low. I mean your run rate on the real estate portfolio is roughly $0.18 a share. So I'm just trying to understand how you get to $0.15. Is there one-time items that we're not thinking about? Is there I'm just not following.
Glenn Rufrano - CEO: First, Chris that's at the low end right.
Christopher Lucas - Capital One Securities, Inc.: Yes. Right that's what I'm worried about because otherwise why not tighten the range.
Glenn Rufrano - CEO: Yes. Blame it on me, I'm a pretty conservative guy Chris. And so we thought it would be important just to leave the same range out there. So there's no there's nothing hidden in that range that would lead you to one conclusion being in the low-end or the high end."
The CEO flat out states that he is "a pretty conservative guy." This gives me further confidence in the fact that the litigation cost guidance is also too high and thus conservative.
Glenn has been praised for the turnaround he's managed so far and rightfully so. The man comes across as straightforward and continues to deliver as is evident by the results since his appointment. Since Glenn is leading the company, it hasn't missed a single earnings estimate and has regularly beat at least the revenue estimate. Then again, REIT investors predominantly care about AFFO, and he has beat analyst estimate twice now on that front. I have no problem believing Glenn on his statement that he is a pretty conservative guy, because the numbers definitely support that claim. I'm estimating AFFO to come in at $0.18 cents a share at a minimum, which will be a cent higher than Wall Street consensus of $0.17 cents a share. My high end of the range of $0.19 cents is based on lower-than-expected litigation costs. In short, this will be an earnings beat.
Disclosure: I/we 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.