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I’ve made no secret of my disdain for dividends, or that category of dividend/income investors who seem to be just plain mental..! Especially the US variety of the breed, it must be said. 😉 I was even moved to write a dividend series: ‘Chasing Some Dividend Tail..?’, Parts I, II & III. I recall some of you enjoying it – and believe me, it was just as much fun writing it! But as with all moral arbiters, there eventually comes a mea culpa – ‘I have sinned, oh Lord…but I was seduced in a moment of weakness!’ And here’s mine, replete with tears:

Oh Lord, I couldn’t resist – I fell for a stock flaunting a (near) 13% dividend…the damn hussy!

Let me introduce you to:   Raven Russia Limited (RUSP:LN)

Note I don’t mean their ordinary shares (RUS:LN) – I invested in their preference shares (RUSP:LN). I bought them in late 2009, so my purpose here isn’t to produce a new write-up – but rather to offer what might hopefully be a useful primer for analyzing & buying similar instruments. [Well, at some point – in the current climate, good credit opportunities are becoming increasingly rare. But see this Tetragon Financial (TFG:NA) write-up – though TFG sports a v different level of risk]. Of course, that’s really only useful if I can reproduce my original analysis & perspective – with the help of the financials & my notes from that period, I think I can do just that (hopefully eliminating the benefit of hindsight as much as possible).

Raven Russia‘s a property investment company focused on the acquisition, development & leasing of class A warehouse complexes in major Russian cities. The key management team, Anton Bilton (Exec. Deputy Chairman), Glyn Hirsch (CEO) & Mark Sinclair (CFO), all came from Raven Mount – which was basically Raven Russia’s original sponsor. Preference shares were first issued in Mar-2009 to strengthen the balance sheet & fund an acquisition of Raven Mount itself.

One should recall, funding a Russian property vehicle was no piece of cake in 2009! Access to (even high interest rate) debt was pretty limited at the time & further equity issuance would obviously have been dilutive. A preference share placing seemed the ideal best solution, but it still had to be sweetened with a high coupon (plus a free warrant (RUSW:LN) per share). The result: A 12% cumulative redeemable preference share.

I didn’t participate, but I’d long been interested in Raven Mount & Raven Russia was also on my radar as a potential Russian equity investment. Late in 2009, I decided to pass on the ordinary shares – they were trading on a 21% discount (to a fully diluted GBP 61p NAV), which didn’t strike me as extraordinarily cheap. And there were other Russian property & general equity investments which I considered equally attractive & that much cheaper at the time. However, the preference shares were trading at an attractive discount to par, and presented a v different risk/reward profile – I decided to investigate further.

Close analysis of the placing document (see Appendix 2, Part A) was key: The GBP 12p coupon, vs. the share price at the time, offered a current yield of almost 13%! The dividend was also cumulative, so if payment was in arrears, interest would accrue at a higher 15-20% rate. And all arrears had to be cleared before any ordinary shareholder distributions could be paid. Of course, actual return would also depend on any maturity/redemption date(s) & amount(s). In this instance, there was no fixed maturity & the redemption amount was GBP 100p per share. In fact, redemption could only occur in limited circumstances – primarily a winding-up, or a takeover or merger, of the company. The company clearly had multi-year growth potential ahead of it, so (rightly, or wrongly) I concluded:

i) Even if the market cap traded at a significant discount to NAV, on occasion, steady/high NAV growth would discourage management & shareholders from considering a wind-up, and

ii) Noting general risk-aversion re Russia, I believed a possible takeover by another UK/European property company was some years away, at a minimum – and the (unlikely) prospect of a Russian takeover would be strenuously resisted. A takeover bid would also need to be at a substantial premium to ensure acceptance, and perhaps include a market based bid for the preference shares as a goodwill gesture (noting many Raven investors held both share classes).

For me, this implied the market price of the shares was relatively unconstrained & mostly dependent on what the average investor might accept as a current yield. And I couldn’t help noting some dividend investors just grab yield & appear oblivious to possible principal risk – this suggested a steady flow of new buyers even at market prices substantially in excess of par.

It’s worth stepping back here – fixed income investment is relatively rare for me (hmmm…except for my largest holding, Alternative Asset Opportunities (TLI:LN), which I consider to be essentially a portfolio of fixed income investments). If I want to lower risk in my portfolio, and/or have quasi-cash on hand, I usually prefer event-driven investments – they’re lower-risk, have a limited time horizon & still offer equity-like returns. But occasionally a compelling fixed-income opportunity shows up…

Now, I’m not talking about busted/distressed scraps of paper – these can require a huge amount of analysis & modelling, a minimum level of legal expertise, and they’re often an opaque/inaccessible asset class for the average investor. I’m looking for a more comfortable middle-ground – something that’s unusual, perhaps misunderstand, suffering from poor technicals & sentiment, and/or is simply stuck in an unattractive sector/market. A current yield of 7.5-8%+ will usually get me interested, but that’s my initial hurdle rate – prospects for capital gain will dictate if I can perhaps ultimately earn 10-15% pa. [Yes, that’s an attractive return in a historical equity context – but anything less & I’d probably plough my cash into an event-driven, or (even better) an equity investment, which I believe has higher potential returns. Yep, tres greedy, I know..!]

Of course, with a fixed maturity date or a right to redeem, the market price will need to be at a pretty significant discount to par to earn that kind of return. And that can be frustratingly rare, especially today – or you’re probably looking at a much more dangerous piece of paper… But as far as I’m concerned, that’s real value investing for you – you can’t just blindly accept the best relative price the market’s offering, you have to plan on a specific (absolute) price & opportunity and then wait around (sometimes years) for it to arrive. If the market mostly makes no sense (in this context), remember there’s always another neglected corner or two to explore – needless to say, this isn’t the easiest form of investing..!

So, clearly, RUSP looked v attractive…

But what about risk? Preference shares don’t have S&P/Moody’s credit ratings, and would you rely on them anyway?! First, let’s dispense with a red herring:  Many investors obviously disliked the Russia exposure (I didn’t) – but frankly, I think it’s pretty damn irrelevant! A fixed income investment should primarily depend on the earnings/assets coverage of the company. In most scenarios, who cares if the company’s making cardboard boxes in Luton vs. investing in Russian warehouses – if you’ve confirmed there’s adequate safety/coverage, you should pretty reliably earn your coupons & then sell/redeem/mature your investment at a (relatively) predictable price.

We first need to do a balance sheet review – the interim results released in Sep-2009 were the most up-to-date at the time:

Raven Russia

Sorry, can’t decipher it? Here’s the link, see page 11.

Since Raven’s a property company, let’s begin with that perspective. Investment property, construction property & inventories amount to $1,054 mio. Loans & net derivatives, less cash, equals $308 mio, which pegs Net LTV at 29%. Of course, preference shares are just another form of leverage (particularly from an ordinary shareholder’s perspective) – if we include them ($223 mio is equiv. to 141 mio shares @ GBP 100p), Adjusted NET LTV rises to 50%. Overall, when a balance sheet includes preference/convertible liabilities, I think an average is the fairest measure – Average Net LTV works out to be 40%. My usual (risk) rule of thumb is to limit Net LTV to 60-65% for a property investment company & 30-40% for a property development company. Looking at the asset mix, Raven’s clearly more of an investment company – but since we’re talking about Russia, let’s split the difference: I’d prefer to see Average Net LTV remain limited to (say) 50%. This comfortably allows a further $107 mio increase in net leverage (vs. the existing level of property assets).

Next, we’ll home in on liabilities. [btw Always think gross – assets & liabilities generally can’t be just offset, for example in a bankruptcy]. Let’s assume things go horribly wrong & then consider the potential implications:

Remember the normal priorities in the capital structure & how they get paid off in waterfall fashion: Secured loans/creditors normally have highest priority & are fully repaid before other creditors receive any payment – so, with insufficient assets, this can mean other creditors & equity get wiped out. In some countries, tax liabilities (which might melt away – but let’s include them, to be conservative) & employee benefits may out-rank secured creditors – otherwise, they’re usually next in line. Finally, we have unsecured creditors, typically recorded as trade & other payables. After that, anything left over goes to the preference/convertible holders, with some occasional dregs trickling down to ordinary shareholders (PIs often don’t grasp how rarely this happens…).

[Of course, if aggressive investors (like hedge funds) hold lower-ranking liabilities or equity, and there’s a proper forum for negotiation, they may claw-back a slightly better recovery. And obviously a bankruptcy triggered for liquidity, not solvency reasons (a tough distinction!), may hold out a little more promise for all classes].

There’s $623 mio (total liabilities, less preference shares) of liabilities that need to be paid off before the preference shares receive a penny (forget about ordinary shareholders here). We can reasonably presume $182 mio of cash would remain unimpaired, and is available. This will reduce priority claims to $441 mio, which must be covered from all other assets – i.e. total assets less cash, totaling $1,232 mio. [It isn’t always the case, but I wouldn’t place much distinction here between assets – e.g. if Russian property prices collapse, what are the chances of collecting 100% of the trade & other receivables?! Also, you may want to exclude intangibles, goodwill, and/or deferred tax assets – but in this case, they’re relatively minor, so it’s reasonable to include them].

So, after satisfying all priority claims, remaining assets will notionally total $792 mio, which offers a full 3.5 times coverage for a 100% repayment of the preference shares. That’s pretty reassuring! But let’s also consider this in terms of potential asset declines (in % terms):

1 – ($441 mio claims + $223 m preference shares) / $1,232 m ex-cash assets = 46% decline in Russian assets > preference shares are still fully repaid

1 – $441 mio claims / $1,232 m ex-cash assets = 64%+ decline in Russian assets > preference shares are fully wiped out

These figures were far better than I’d expected (considering the preference share pricing)! Based on my own evaluation of Russian economic & property fundamentals at the time, and reading management’s commentary on Raven’s current & future prospects, I believed it was highly unlikely assets would ever decline 46%, let alone a catastrophic 64%+… This, of course, presumes the assets are fairly valued in the first place…

But current annualized net operating income was already at $70 mio – with pre-lease agreements (PLAs) & letters of intent (LoIs) that would rise to $80 mio, and it was estimated to reach $128 mio with a fully let portfolio (equiv. to an unleveraged 12% yield). Capital & rental values per sqm were also provided by management. These yields & values were fairly easy to confirm against external benchmarks, and they certainly appeared adequate to support Raven’s current property valuations (so it’s reasonable to assume a similar read-through for other balance sheet values).

Since it’s Russia (& large-scale FX hedging is impractical), it’s also worth assessing the potential impact of a collapse in the Russian ruble. Fortunately, the Russian market continues to operate based on USD values. This is slowly changing, with more ruble-denominated deals occurring (mostly rent agreements), but these still have USD-RUB FX adjustment clauses included to compensate for any excessive RUB decline. That’s not to suggest any such decline would be painless – and think about what the accompanying economic climate might look like anyway… But then again, don’t forget you have to see a 46-64% decline in asset values – regardless of how it’s caused – before the preference shares get partially/fully wiped out.

Now, if this was a regular company, we should probably spend just as much time analyzing the P&L and cashflow statements. However, Raven’s a property company, so: a) If you get comfortable with leverage & the balance sheet, most of the time you can expect rental income to (at least) cover admin. & interest expense, and b) I find property P&Ls about as useful as tits on a shark, anyway. But we can’t ignore possible outliers – a review of the cashflow statement instead should identify any potential risk:

RR Cashflow

Again, this might be unreadable – here’s the link again (page 12), remember to annualize everything.

Cash generated from operations is $31.7 mio. Operating free cashflow (i.e. after capex) is similar, at $31.2 mio. [Of course, this completely ignores ongoing net construction spend, which we’ll treat as a balance sheet transaction. Further construction expenditure will be funded from cash (and/or increased borrowings). Either way, this increases net leverage – but remember property assets increase also. It will obviously be important to monitor the evolution of the balance sheet (in light of our preferred 50% limit on Average Net LTV)]. Net interest expense (on loans) amounts to $22.0 mio. And finally, the annual preference share dividend can be calculated as $26.8 mio ($223 * 12%).

This nets out to an underlying annual cash outflow of $17.5 mio – not an ideal result! This will also need to be absorbed, for the moment, by increased leverage. However, it does appear to be a temporary phenomenon – rental income’s ramping up aggressively. Once the cashflow statement catches up with current annualized net operating income of $70 mio (and ideally $80 mio, presuming the PLAs & LoIs complete), this situation should hopefully be corrected. Remember, there will probably be no corresponding increase in admin. expenses, the preference share dividend, or interest expense (as near-term cash needs can be comfortably funded from cash on hand). Again, this requires careful monitoring.

Putting all this together, looking at available income/risk alternatives, considering historic preference yields, and with some anticipation of continued QE & financial repression, I was pretty hopeful the current yield could eventually compress to around 8%. Which was a pretty bloody distant prospect at the time..! But what does that imply?! Yup, a potential GBP 150p – and lo & behold, that’s the closing preference share price today!

At this point, I could perhaps envisage an eventual 7.5%, maybe even a 7% current yield – which might be worth another GBP 10-20p on the share price. But the risk of a significant price decline has now increased substantially: We could (abruptly) experience rising inflation/rates, changing Russian macro/micro fundamentals, and/or a general reversal in market sentiment or risk appetite. All of which might impose a much larger price hair-cut. And don’t forget there’s still that (small, but growing?) possibility of a ‘forced‘ redemption at par. [I won’t do it here, but if you’re a preference shareholder you’ll obviously need to take a fresh look at Raven’s current balance sheet values & leverage. Don’t forget the market price is now substantially above par, so you’ll have to decide if you rely on a preference share balance sheet value of par, or if you want to adjust it to reflect market value. Or perhaps you might want to evaluate both – arguably, each provides useful insight].

Frankly, I doubt any fresh buyer is getting a good deal here now (though obviously there’s fresh buyers every day!?). I evaluate in a similar fashion – when reviewing holdings, it’s far better to ignore your cost base & instead ask whether you’d actually buy a holding fresh? I also rank holdings constantly against new opportunities. Feeling fat & happy about a profitable holding is a comfortable, but silly, approach – because now it may well present a far less desirable risk/reward proposition vs. some of your potential buys. RUSP now offers an 8.0% current yield & a far greater chance of principal loss, than gain.

And so, I’ve sold out…

And those tears I mentioned originally…well, actually, they’re tears of joy:  Vs. my average net entry price (I deduct dividends received against my average purchase price – not an exact return methodology, but close enough), I’ve realized a 126% gain in a little over 3 years.

Or maybe they were just crocodile tears:  It really wasn’t about the bloody dividends – they actually only contributed a third of my total gain, the major portion actually came from capital gains!

So yeah, I’m not sorry, and I’d bloody well do it all over again:  Dividends are a side-show & dividend investors can just suck it! Let’s stick to real value investing, and just keep figuring out fair values & upside potential – after all, dividends will never tell you if something’s actually a good investment, but they can certainly lead you into a bad investment…

Oh btw, here’s those links again:   ‘Chasing Some Dividend Tail..?’, Parts I, II & III.