Jul 5, 2010
Gyrodyne: Undervalued and at 52 Week Highs
Most value investors talk about using the 52 Week New Lows list as a way of picking stocks. This makes a lot of sense, after all, you are looking for companies that are trading at $0.50 cents but are really worth $1. I’ve been testing another strategy though – the 52 Week New Highs list. This seems counter-intuitive. But it makes a lot of sense. Besides investing in “generals” — stocks that I think are undervalued on the basis of their business models, I also look out for special situations.
The way I define a special situation is a type of investment that has some sort of transaction (typically a balance sheet event) which unlocks or realizes value. And you can find a lot of complex special situations using the New Highs list. Some will be there because they are getting acquired – so you’ll try to take a merger arbitrage position and hope to earn the spread between the acquisition and current price. You’ll also find companies that are passing through a drug trial our winning a court settlement.
Today we’re going to focus on a court settlement. The situation is Gyrodyne of America (NASDAQ:). The stock is hitting 52 week highs, but I actually think there is substantial room for appreciation.
Gyro just announced that they won a court settlement from the State of New York. Here’s what happened:
“ST. JAMES, N.Y., June 30, 2010 – Gyrodyne Company of America, Inc. (NASDAQ:GYRO), a Long Island-based real estate investment trust, announced today that the Court of Claims of the State of New York issued an opinion requiring the State to pay to Gyrodyne an additional $98,685,000 for land appropriated in 2005. Under New York’s eminent domain law (the “EDPL”), Gyrodyne is also entitled, subject to EDPL Section 514, to statutory simple interest on the additional amount at a rate not to exceed nine percent (9%) per annum from November 2, 2005, the date of the taking, to the date of payment.
The opinion was issued in connection with Gyrodyne’s claim brought in April 2006 for just compensation for the 245.5 acres of its Flowerfield property in St. James and Stony Brook, New York (the “Property”), taken by the State. The State had paid Gyrodyne $26,315,000 for the Property at the time of the taking, which Gyrodyne elected, under the eminent domain law, to treat as an advance payment while it pursued its claim.
In its opinion, the Court agreed that the State had improperly valued the Property and misapplied the eminent domain law’s requirement that just compensation be determined based upon the highest and best use and the probability that such use could have been achieved. Applying this standard, the Court determined that there was a reasonable probability that the Property would have been rezoned from light industrial use to a planned development district, thereby resulting in the aforementioned award to Gyrodyne.”
I look at situations where a court verdict is announced, a drug trial passes, or a certain earnings target is met as milestones in my investment process. So if I think a stock is undervalued, I will look at whether or not the company meets the milestones that I put up to, check its progress against my thesis. The benefit is that when a company meets its milestones, part of the uncertainty or risk behind your thesis goes away. Gyrodyne is a good case of that.
So let’s look at this on a sum of the parts basis:
$99.0 (settlement)
+ 41.0 (interest payments)
+ 34.0 (book value of real estate)
+ 1.10 (cash & cash equivalents)
- 21.5 (total liabilities)
= 153.6 / 1.29 shares outstanding
= $119 per share.
With the shares currently trading around $73, you get a potential gain of 63%. To me, this is a conservative estimate of liquidation value because the real estate is booked at cost. My guess is that some of it may have appreciated since they acquired it, but would rather not speculate. The company also owns an interest of a bit less than 9% in a Florida development called “The Grove”. Again, I would rather not speculate as to what the value of that interest really is.
Typically, whenever a company has a large cash balance, they tend to be greeted with skepticism. One of the risks companies with high cash balances is the fact that they might squander the cash horde. I think there are two reasons for why I would handicap this as a low possibility:
1. Shareholder Activists
Phil Goldstein of Bulldog Investors owns 17.46% of the stock. Two other partnerships own a combined 15% of the stock (River Road Asset Management, Leap Tide Capital). Phil Goldstein is a notoriously tough activist, he has been pretty big on forcing close-ended funds to liquidate when trading at discounts to NAV. I think there is a good chance Goldstein and the other investors will make sure the money from the court case is used in an accretive manner.
2. Reinvesting
So far, the company has reinvested capital into a series of medical office parks located in New York and Virginia. These acquisitions have worked out pretty well. There are certain start up costs that are incurred which makes reported income not the best figure to represent their economic value.
Instead, if you were to take:
(Rental Income – (Rental Expense – Depreciation)) /
(Real Estate Assets, Net + Accumulated Depreciation) =
(4,834 – (1,943 – 690)) / (34,192 + 3,701) = a yield of 9.4%.
Overall, that is a pretty strong figure and representative of the fact that the management team knows what they are doing. I don’t think they will squander the cash.
3. Taxes
One of the risks to the thesis is the fact that even if the NY State amount is paid out, some of it might have to go to taxes. I think there are a few things to keep in mind. As a REIT, the company typically pays minimal income taxes:
Effective with an election dated May 1, 2006, the Company operates as a real estate investment trust (a “REIT”) for federal and state income tax purposes. As a REIT, the Company is generally not subject to income taxes. The Company is subject to the “built-in gain” rules. Under these rules, taxes may be payable at the time and to the extent that the net unrealized gains on the Company’s assets at the date of conversion to REIT status are recognized in taxable dispositions of such assets in the ten-year period ending April 30, 2016. To maintain its REIT status, the Company is required to distribute at least 90% of its annual REIT taxable income, as defined by the Internal Revenue Code (the “Code”), to its shareholders, among other requirements. As of December 31, 2009, the Company had cash and cash equivalents of $868,786 and a CD for approximately $203,000 maturing in March 2010, thereby having total funds available in 2010 of $1,071,786. The Company anticipates having the capacity to fund normal operating, general and administrative expenses, and its regular debt service requirements.
So far, when receiving settlements, the company has reinvested them in like properties to avoid paying taxes:
The Company initially invested the Advance Payment in short term U.S. Government securities and interest bearing deposits which were valued at $26,184,383 and $238,593, respectively, as of April 30, 2006. Subsequently, the Company invested in hybrid mortgage-backed securities fully guaranteed by agencies of the U.S. Government which are qualified REIT investments. During 2009, the remaining investments in hybrid mortgage backed securities were sold, with the balance of the proceeds applied toward the acquisition of the Fairfax Medical Center – see below.
In accordance with Section 1033 of the Internal Revenue Code, if the Company replaces the condemned property with like kind property within three years (or such extended period if requested and approved by the Internal Revenue Service at its discretion) after April 30, 2006, recognition of the gain for federal and state tax purposes from the disposition of 245.5 acres is deferred until the newly acquired property is disposed of. In June of 2007, June 2008 and March 2009 the Company acquired the Port Jefferson Professional Park, the Cortlandt Medical Center, and the Fairfax Medical Center, respectively. These purchases totaled approximately $28,805,000 and represent the completion of the tax-efficient reinvestment of the condemnation proceeds.
If they could continue to reinvest in such projects, I don’t see there being much likelihood of value destruction. In addition, I think the activist element at the company might push for the company to put itself up for sale. It might be an attractive target for REITs expanding their portfolio of healthcare facilities.
Risks
1. NY State Appeals
It’s possible that the state could try to appeal the verdict. I’m not too sure that they would though. This case has already been tied up for four years and they cannot submit new evidence. I don’t know what kind of legal avenue they could pursue here.
Moreover, as per the current verdict, each year the state does not pay Gyrodyne, 9% accrues. It really is not in their interest to drag this out.
2. Taxes
If the company decides not to reinvest the capital within the given time frame (for the advance payment they had three years), they’d likely have to pay a 15% tax. That would reduce our per share valuation by $16 from $119 to $103. I don’t think this action is likely – just because it is a destruction of shareholder value and there are enough funds with concentrated positions who would not see this as being in their interest.
3. Illiquidity
With only 1.29M shares outstanding, the company trades in small blocks of shares. The lack of liquidity might be problematic for some because it would result in a wider bid/ask spread than usual. It also means that you cannot just place a market order. As a benefit, most larger funds are going to be kept out which creates opportunities for small investors.
Conclusion
Most of my valuation assessment depends on the historical cost figures for certain assets. The fact is, the real estate might be worth a good deal more, especially when you consider the fact that their medical offices are performing well. To get more precision in our analysis, we would need to dive deeper and come up with more developed valuations for each property and the orange grove investment in Florida. So, there might actually be more value in the company’s assets beyond their recorded cost. But right now, I look at that as another aspect of our margin of safety with Gyrodyne.
With shares currently trading around $73 and the potential to make $119 or a 63% return — I see Gyrodyne shares as a bargain because it is trading below liquidation value with a substantial margin of safety.