Participating preferred stocks are unusual in the public market, but I’ve seen plenty of these in Venture Capital for earlier stage companies. While diving into the details, I licked my chops in excitement.
That excitement stemmed from knowing these funny beasts are typically sold by an issuer from a position of weakness. In other words, Raymond James, the lead underwriter for the Farmland Partners Series B, Participating Preferred Stock (FPI.PB) in 2017, assessed that investors required additional kickers, or sweeteners, beyond a plain vanilla 6% cumulative preferred stock. In this case, Farmland Partners (FPI) had to agree to two very significant kickers:
- If the entire B preferred is not redeemed by September 2024, the dividend jumps from 6% to 10%; and
- Whenever the B Preferred is redeemed, FPI will have to measure the increase in value of its land assets against the 2017 assessed value and pay to the B Preferred 50% of any increase.
Thesis and Assumptions
When you call up FPI.PB right now, you will see a 6.06% trailing twelve months (TTM) yield on your screen that I believe that materially understates the most likely outcomes. By taking a closer look at the mechanics of this B Preferred, we will uncover valuable gems in those sweeteners.
Please note that I have calculated YTC in these cases assuming:
- A shareholder qualifies for the dividend paid at the end of this month;
- These dividends are not reinvested; and
- There has been no increase in the underlying farmland since 2017.
Because there is already much written on Seeking Alpha about Farmland Partners and its relative safety on the cash flow side, I highly encourage investors to read these or the company’s 10-Q and 10-K SEC filings if they are not already familiar with this agriculture REIT. Instead, this analysis assumes you are already comfortable with the underlying cash flows and are looking more deeply to analyze the FPI.PB expected performance.
The FPI Participating B Preferred kickers create a twofold upside far beyond 6.06%:
- The first call date for Farmland Partners is September 2021 – just 12 months away in a market environment that appears to support replacing that preferred with something less expensive to FPI; and
- This preferred is a Participating Preferred which includes revaluing the underlying property in the FPI portfolio to measure whether the B Preferred receives part of the current asset increase (please note there is no downside adjustment, only upside).
Quoting directly from FPI’s 10-K filing, the B Preferred Stock receives the sum of:
- The Initial Liquidation Preference ($25), plus
- An amount equal to 50% of the cumulative change in the estimated value of farmland in the states in which the Company owned farmland as of June 30, 2017 (measured by reference to a publicly available report released annually by the National Agricultural Statistics Board, the Agricultural Statistics Board and the U.S. Department of Agriculture) (the “FVA Adjustment”), plus
- All accrued and unpaid dividends, subject to a 9.0% cap on total return (the “Final Liquidation Preference”).
Why FPI Would Replace the Preferred Next Year
This is a balancing act that I am certain FPI’s CFO and its advisors are actively tracking over the next year because a lower interest rate environment is favorable to:
- The underlying businesses who lease property from FPI;
- Lower preferred dividend costs and easier terms for a replacement preferred stock or bond issuance; and
- Increasing the value of the underlying land (lower cap rates can hugely increase land values).
The key intersection that most likely only FPI and its advisors will know with any reasonable certainty is the area where a lower preferred dividend without a participating feature beats the total redemption cost noted above. They can be ready to execute when the stars align during the early redemption period from September 2021 to September 2024.
I prefer scenario testing to examine performance or underlying volatility under different conditions. If you are interested in more on this topic, please see my new blog: A Side Road on Volatility and Beta.
To get a better sense of how an investor can read into what is likely happening over the next 12 to 48 months with FPI.PB, let’s examine four different economic scenarios in which we might find ourselves:
- Economy continues to rebound slowly through 2023 (the scenario on which I have based my portfolio);
- Economy recovers more quickly;
- Economy slides into recession due to a variety of existing risks; and
- Economy dives.
Economy Continues to Rebound Slowly
In this scenario, interest rates remain low, agriculture demand remains steady and the stock market is trading within a relatively stable range.
It is highly likely FPI will redeem next year provided total cost, including any participation payout, is less than the savings from issuing a new preferred with a lower dividend and less onerous terms.
In that scenario, my yield-to-call (YTC) is 9.17% plus any participation payout on asset appreciation. That’s a mighty premium over the 1 year treasury rate. With all the equity beneath me to protect the preferred and stellar rent collection track record, this looks very undervalued to me with more than double the yield the underlying stock will likely give me over the next 12 months.
Economy Recovers More Quickly
In this scenario, interest rates rise again, agriculture demand is robust and the stock market is trading up 12% from today.
It is less likely FPI will redeem next year due rising interest rates pushing higher preferred costs and a more likely participation payout on asset appreciation.
In that scenario, redemption more likely extends out to 2024 and my YTC falls to 6.86% plus any participation payout on asset appreciation. That asset growth would be due to strong economic conditions. Additionally, any time between next September and September 2024, FPI can redeem should the stars align properly. In any event, this scenario significantly improves my expected YTC beyond the 6.06% TTM yield on my screen.
Unclear whether this scenario is better or worse than a slow recovery.
Economy Slides into Recession
In this scenario, interest rates remain low, agriculture demand is slightly down and the stock market is trading down 10% from today.
It is more likely FPI will redeem next year if the market would be receptive to a cheaper preferred due to investors chasing yield. The participation feature would be harder to eliminate as an inducement in tough trading conditions and there is a low likelihood that the B Preferred would receive a participation payout on such a redemption.
In that scenario, my yield-to-call is a solid 9.17% for one year money which I will take all day in that environment. I would also take a hard look at any Preferred FPI might issue to replace the B.
This scenario is worse than a slow recovery and I have still done well.
In this scenario, interest rates could be zero to slightly negative for a period, agriculture demand is spotty and the stock market is down 25% from today.
Forget early redemption – the new issue market is closed. That puts us on track for a 2024 redemption or a hike to a 10% dividend rate starting in October 2024. That’s a tough pill for FPI to swallow and I’ve got to believe, short of absolute disaster or a huge sudden spike in interest rates in 2024, this will be redeemed without a participation payout, or a 6.86% YTC.
This is a worst case scenario in which FPI might not be able to redeem the B preferred by 2024. I think we are unlikely to experience this scenario and it can never be fully ruled out. And still, we get a nice return on our dollar here.
Even when I stress test the cash flows to the B Preferred, I don’t realistically see any out-sized risk of default on the downside and I can grab a significant yield premium to prevailing government bond rates that feels more than worth the downside risk. That’s not easy in what I think is a frothy stock market, so I am very bullish on this investment.
I hold a long position that represents 7.74% of my current portfolio and I am likely adding to this position over the next few months.
Sailboat Portfolio Update
As of the close of business on 9/14/2020, it has been a month and my tough little sailboat has seen a +1.01% change in value while the Dow and S&P 500 are -2.3% and -3.5%, respectively. When I add dividends by measuring my actual income against the Dow and S&P 500 theoretical annual yields, which currently stand at 2.65% and 1.71%, respectively, I do even better.
For September, I have some quarterly dividends hitting in addition to my monthly near cash equivalent and Realty Income (O) payments. I am expecting 0.61% actual September income versus today’s 0.22% and 0.14% theoretical monthly yields (the annual yield divided by 12) for the Dow and S&P 500, respectively that boosts my overall performance as follows:
- Me: 1.01% +0.61% = +1.62%
- Dow: -2.3% + 0.22% = -1.91%
- S&P 500: -3.5% + 0.14% = -3.64%
We are outperforming the Dow and S&P 500 by 3.53 percentage points and 5.26 percentage points, respectively, in just our first month thanks largely to downward moves in the major indices and some nice dividend captures.
Please note that as my time series grows larger, I will present a graphical performance line that shows monthly movements for easier digestion.
Disclosure: I am/we are long FPI.PB. 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.