Whitestone REIT Proxy Vote Could Unlock 25% Upside

Summary

• WSR's proxy vote takes place on May 17 at the annual shareholder meeting.
• The blue voting form will attempt to reduce management compensation to a reasonable level.
• The reduced compensation could improve FFO by $0.25 per share and increase market price by about 25%.

As of 5/1/18, 2^nd Market Capital holds 815,031 shares of Whitestone REIT (NYSE:WSR) or roughly 2% of outstanding shares and we have recently voted our shares against management in the proxy battle over director elections.

The Buy Thesis

Whitestone REIT has beautiful assets in some of the best submarkets with superior household income and population growth in the relevant trade areas. This has led to strong same store growth which we think will continue for the foreseeable future. Despite the quality of its portfolio, WSR trades at a sizable discount in both NAV and Core FFO multiple as a result of its major problem - management compensation. This problem is on the cusp of being remedied through a proxy vote and once dealt with, we believe 25% upside will be unlocked.

This article will detail the egregiousness of compensation and follow with a discussion of the proxy, which could be a catalyst for substantial value recognition for shareholders.

Misalignment and gouging

Even in these challenging times for retail, Whitestone’s shopping center assets have performed wonderfully with continual favorable leasing, including significant improvements in occupancy levels.

Source: SNL Financial
In recent quarters, many shopping center peers have struggled just to maintain occupancy. WSR has a 100-basis point improvement over the last 12 months and is guiding for another increase of 20 to 120 basis points in 2018 (per the 4Q17 earnings release).

Further, while other shopping centers are giving rent concessions, WSR is increasing same store NOI. In 2017, same store NOI in the wholly owned portfolio grew 2.6%. Guidance for 2018 calls for another 2.5% to 3.7% same store NOI growth in the wholly owned portfolio (2.0% to 3.5% for total portfolio).

But here’s the problem; almost none of the growth has actually made it to shareholders with almost all of it going straight to management’s pockets.

Note that FFO core/share has grown from $0.92 in 2011 to $1.25 in 2017. However, FFO, as defined by NAREIT, is still languishing at $0.93.

Source: WSR 2017 supplemental

What’s the difference?

Well, in calculating FFO Core, management likes to add back share-based compensation which came in at a whopping $0.28/share.

Source: WSR 2017Y supplemental

All those shares issued to management dilute shareholders and are a real expense. Management compensation is not just high, but extreme. Allow us to compare WSR’s G&A with that of peer shopping center REITs.

Source: SNL Financial

WSR’s G&A/revenue in 2017 was 17.87%. A majority of the shopping center REITs are single-digits on this metric and even Acadia, the second most expensive, comes in at 11.61%. This compensation is truly egregious and is preventing shareholders from realizing the value that should have been created by their investment. Further note that this gouging is not a 2017 phenomena, but a consistent pattern for the last 5 years.

In absolute dollars, 2017 G&A came in at $22.324mm which is about 5.2% of WSR’s market cap.

Source: SNL Financial as of 5/2/18

It is exceedingly difficult for a company to grow when 5% of its market cap is going out the door each year.

G&A has been a problem since WSR’s inception, but for the first time, shareholders now have an opportunity to do something about it.

The Proxy Vote

At the May 17^th annual meeting of shareholders there will be a vote to elect board trustees along with a vote on a compensation package.

The white voting form put out by WSR is calling for nomination of

• Mahaffey
• Mastandrea
• Berry

In addition, the management supported white voting form is calling for approval of the compensation package.

An activist, KBS, which owns approximately 10% of outstanding shares, has put out an opposing blue proxy. This is calling for the appointment of

• Fearn
• Snyder

The blue form also requests that voters deny the compensation package.

KBS has stated that its goal in replacing certain directors is to keep WSR’s management in place, but to bring compensation down to a reasonable level. While two directors would not be a majority and therefore cannot enforce this goal, it will go a long way toward improving oversight on compensation.

So far, Mastandrea (WSR’s CEO) and his team have done a reasonably good job on the operations side. The acquisitions have been well-located and at prices that have produced excellent IRRs. It seems reasonable to us to leave this skill in place and simply bring their pay package back down to earth.

Therefore, we have voted our roughly 2% of shares outstanding with the challenger’s blue voting form.

Chances of passing

Potential obstacles to the new directors winning are the couple percent of the stock owned by management which will almost certainly vote on the white form and the large passive ownership.

Source: SNL Financial

With 13.5% owned by BlackRock (BLK) and 11.8% by Vanguard, these will be the swing voters. It can often be hard to predict how ETFs will vote or if they will vote at all. That being said, recent news greatly improves the chances Vanguard and BlackRock will vote blue.

NEWPORT BEACH, Calif., May 4, 2018 /PRNewswire/ -- KBS Strategic Opportunity REIT, Inc. ("KBS") today commented on the recommendation by a leading proxy advisory firm, Institutional Shareholder Services ("ISS"), that its clients vote FOR the election of KBS's independent nominees Kenneth H. Fearn, Jr. and David E. Snyder to the Whitestone REIT ("Whitestone") (NYSE: WSR) Board of Trustees (the "Board"). ISS also recommended that shareholders vote in favor of the proposal to declassify the Board.”

ISS is quite influential for mutual funds and other big entities. As such, its blue recommendation will likely swing quite a few votes in favor of change.

The blue vote can win even if the passive investors and management vote white, but it will be more difficult as it would require a large percentage of the active investors to vote blue.

I think it is more likely than not that the blue voting form will win. The shareholders with whom we have discussed WSR are fed up with the excessive compensation and would like to see some change. Most of those with whom we have discussed this idea are retail investors so I do not know how many shares they control, but the opinions on management compensation seem unanimous in agreement with us.

As an investor, we are always looking at intrinsic value and if blue wins, this value can be unlocked. To ascertain what WSR is worth, let us go over its property portfolio.

Beautiful portfolio with excellent fundamentals

WSR’s properties are in significantly more affluent areas than those of its peers.

Source: WSR presentation

Only FRT has wealthier locations and FRT trades at a premium multiple. If we look at population growth and income growth, WSR actually looks better than FRT.

Source: WSR presentation

While there is obviously bias inherent in these charts as they were created by WSR, the information they present is factual in nature.

$75.6K median household income growing at about 7.8% along with nearly 9% household population growth is quite impressive. These excellent locations have translated to consistently strong same store NOI as seen below.

Note that WSR’s same store NOI has remained positive even in this period in which retail is struggling.

With this quality in mind, let us look at valuation.

Valuation

Consensus NAV for WSR is $14.38, or roughly 30% above today’s price.

Source: SNL Financial

NAV refers to the value of the assets. In other words, it does not factor in things like G&A as this expense is after the NOI line and not tied to the assets.

The current market price reflects the value of the assets less the dilution from excessive G&A expense.

Given $0.93 of NAREIT FFO in 2017, WSR is trading at about 12X 2017 FFO. This multiple strikes us as appropriate and I think WSR is approximately fairly valued at the current level of compensation. This is where the value unlock comes in.

If the blue vote wins, the new directors along with pressure from shareholders would likely be able to bring compensation in line with peers. This would knock approximately $10mm off of the G&A annually which divided over roughly 39mm shares is about $0.25 of annual savings.

This would bring run-rate NAREIT FFO up to $1.18 which at the same 12X multiple would generate a market price of $14.16. Unsurprisingly, if compensation is appropriate, the proper trading price would be fairly close to NAV. A fair value of $14.16 implies just over 25% upside from the unlocked value.

Risks to ownership

While WSR has thus far been fundamentally nearly immune to the retail downturn, macro retail health remains a concern. Anyone participating in this trade should keep a close eye on retail sales and potential bankruptcies.

More specific to the WSR situation, there is risk that the white voting sheet wins the vote. In this case, NAREIT FFO will likely remain below a dollar a share and not cover the dividend. WSR has existed in this fashion since its inception so it would not be a critical failure, but it would remove the upside potential associated with unlocking the value.

There are also some risks to the blue voting sheet winning the vote as KBS often operates through external management. If the new directors were to steer WSR into an externally managed direction it would likely reduce the multiple at which the stock trades. This is not what their stated intentions are, but perhaps once they get a foothold they may become emboldened and try something of this nature.

Disclosure: 2^nd Market Capital and its affiliated accounts are long WSR. This article is provided for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer. Information contained in this article is impersonal and not tailored to the investment needs of any particular person. It does not constitute a recommendation that any particular security or strategy is suitable for a specific person. Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. The reader must determine whether any investment is suitable and accept responsibility for their investment decisions. Dane Bowler is an investment advisor representative of 2MCAC, a Wisconsin registered investment advisor. Commentary may contain forward looking statements which are by definition uncertain. Actual results may differ materially from our forecasts or estimations, and 2MCAC and its affiliates cannot be held liable for the use of and reliance upon the opinions, estimates, forecasts and findings in this article. Positive comments made by others should not be construed as an endorsement of the writer’s abilities as an investment advisor representative.

Analyst’s Disclosure: I am/we are long WSR. 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.

Comments

[linkdonald]

While I appreciate the facts on the ground in this article and the informed possibilities, I see little to be optimistic about. Compensation votes are advisory, change of two directors seems ineffectual and corporate mind set seems little changed. Rather than deep sea fishing with this one, get something already performing like STORE or SPG.

[Javelina]

Looks like Mr. Market approved the winning WHITE CARD vote. :))))

[Gators2]

Plus the shareholders are going to have to eat 3/4 to 1 million for WSR to fight the proxy battle to keep the status quo. Put that in your pipe and smoke it. I should have sold at 12.15 my average on a reduced position but figure I’m ahead by over 4 bucks on the dividend. Keeping my position hoping the ducks can fly straight.

[Gators2]

By the time Mastandrea comes up for re-election he will be 78 and probably retire after he has 3 more years to sack the company. Maybe they will tone it down some or he may double down and really stick it to shareholders. Interested to see what the vote count was and if he was able to rein in institutional holdings. If he did I’m sure there were some promises made. “ Promises made during a tempest storm are soon forgotten in calm waters”. Old sailors saying.

[Po No Mo]

"at the Annual Meeting, Whitestone shareholders did not approve, on a non-binding advisory basis, the Company’s executive compensation,"

But mgmnt kept their directors.

[cksvensk]

Ugh. I guess the big shareholders didn't want a disruptive mess. Board declassified though. Stock relatively flat.

So, mgmt gets another shot and if they don't actually address this issue, there will be another uproar. Will be interesting to see just how brazen Mastandrea is going forward.

[User 19396501]

yeah. too bad. more of the same to follow

[Gregicon]

Best article yet on showing how, exactly, management comp at WSR differs from the norm. Great job! 5K shares voted blue - don't care who wins, as long as the message is received and shareholders start to benefit more than management.....

[reber25]

So there is a chance of WSR winding up in a legal mess if this struggle continues...not for me.

[RNArizona]

How is their occupancy rate these days? I live near several of their properties in affluent areas of Scottsdale, and when I checked several months back it appeared that they had lots of vacant space available. Yes, the properties are nice and in very good areas, but I'd rather see the shop spaces full.

[The Boy Plunger]

md corporate law specifically allows corporations at their discretion to eliminate directors and officers personal liability. mastandrea has been in 3 proxy fights, kbs zero. good luck.

[posane3]

At the risk of displaying my profound ignorance, may I suggest that if the management actually keep their ill-gotten shares, rather than selling them instantly, then their financial interests begin to align with rest of us shareholders. They might actually enjoy getting those nice dividends, just as we do.

[Gators2]

Dane. I think this article and others I have read make for a compelling case to vote for the Blue proxy card which I have done. What shareholder would want management to keep getting excessive executive compensation as his or her expense? If the executive compensation goes down, there is room for the dividend to be actually covered and even go up which would in turn raise the share price. I can’t imagine a shareholder voting to limit his dividend.

[cksvensk]

Thanks for the article. I voted 6400 share blue but am skeptical about winning. Regardless, I think it will be close. My question is, given mgmnt's own rhetoric about bringing g&a down, will this close fight light a bigger fire under their butts? I think it has to, as this could easily happen again in acouple of years if no progress has been made.

[Dane Bowler]

ckvensk,

I think that is a valid point. G&A will likely drop either way, but I think it will drop by substantially more with a blue vote.

[User 19396501]

You underestimate greed and arrogance, it is spelled M-A-S....well you get the rest.

[User 19396501]

Overall this is a good article. It is a nice portfolio but they also paid handsomely for some of these assets, too much in my opinion, and have diluted the shareholders. This is all the more reason why out of control A&G expenses have to be curtailed. They are running out of gas on the dividend and at some point you just cant keep leveraging the asset base or continue to raise more dilutive equity to just keep paying the dividend. CEO is running this thing like it is a 6.0B market cap company, not a 300M market cap company (or whatever it is). If blue wins, price will pop, then the hard work begins about bringing more dollars to the bottom line.

[The Boy Plunger]

a kbs win is not necessarily a good thing, it triggers a change of control payment ($30mill) to mgt and does not mean anything will change.

[Dane Bowler]

The Boy,

I do not think it triggers a change in control payment as management will remain in place.

They will simply be paid less.

[The Boy Plunger]

you should read the proxy, if an activist wins a board seat through a contested proxy then it triggers the change of control provisions. fact.

[Javelina]

I voted my 15k shares white. I will continue owning WSR whichever way the vote goes. Any dip and I will add more. Love the high yield monthly paid dividend.

[User 19396501]

So you doubled down when the price recently cratered?

[Javelina]

ponzifinder: Not this time due to taking advantage of adding to other investments. Good investing.

[User 19396501]

But you say you always buy on the dips....and that was the biggest deep this stock has ever seen!

[davidbolyard]

Thanks for the article. I have voted blue.

[Julian Lin]

Nice article and congrats on a top idea!
Hope you win!
Best,
Julian

[Dane Bowler]

Thanks Julian

[Pinguino Investments]

I voted blue. I will sell if management wins, and I bet others will, too.

[Dividend Income Investor]

I voted Blue also but doubt I will sell if management wins. I love the 8%+ dividend and love their investments.

[CJoyce316]

Yeh I sold a while back on this issue. Most of future free cash flow will come from increase in occupancy rate but with management endless dilution the div will never be raised. Since div is underwater now this is a troubling issue.

[CJoyce316]

Honestly STOR and VER are slightly more attractive due to the longer term div raises, particularly VER.