ARCP making headlines

Reality Capital Properties (NYSE:ARCP) has been making a lot of noise lately as key members of management are suspected of committing fraud. There have been a lot of comments both negative and positive. One side says "Fraud! Sell!" and one says "Buy when people are pessimistic - WB". For me the voice of reason was the conference call where some important factors were mentioned. The Conference Call can be read in its entirety HERE.

So what happened?
The original announcement can be found HERE but in short review by the Audit Committee finds issues with the quarterly reports so far this year and says they should no longer be relied upon. The annual report for 2013 is also being looked at since it was signed of by the same people who are responsible for the first two quarters of this year. However, early indicators say that there is nothing wrong with the numbers from 2013.

What was the mistake?
2014 Q1 AFFO (a non-GAAP measure) was incorrectly calculated which resulted in a AFFO 3 cents higher than the actual. This lowers Q1 AFFO to 0.23$ from 0.26$, none of the items in SEC filings were incorrect just the AFFO numbers. AFFO is something that every rate calculates on their own and it can vary between different REITs. Investigation and forensics indicate that there was no intent to overstate AFFO and that it was characterized as an error.
The main issue is Q2 where they had found that a correction was intentionally put in to hide the error in the first quarter. David Kay had the following to say:

In the second quarter, the company changed its method of presentation to one -- that of a gross presentation. Perfectly acceptable to change it, and the numbers on a per share basis would be comparable under either method. Under the gross method, we used 100% of the net income, add back 100% of the add-backs to get to AFFO per share and divide it by the total weighted average shares outstanding, which would be the common as well as those of the OP holders, or the noncontrolling interest holders, to come to AFFO per share. That calculation included a number that went into there in order to conceal the error from the first quarter. The best way that I can describe what happened there is that we don't have bad people, we had some bad judgment there. And we had 2 employees which have resigned as a result of the effects of that calculation and the nondisclosure of the error in the first quarter.

What was the reaction?
CFO Brian Block was replaced by Michael Sodo, who previously was the director of financial reporting and treasury.  Chief Accounting Officer Lisa McAlister is being replaced by Gavin Brandon.
Reports for the first and second quarter will also be republished as soon as possible, the annual report for 2013 will also be looked at. According to David Kay, the cumulative effect for the Q1 adjustment for the entire year should be somewhere in the $0.02 to $0.025 range since the average number of shares as increased since then.

What about the feature?
Of primary interest was that the dividend is coverable for foreseeable feature and that the changed AFFO guidance will not change this as the changes in AFFO are one-time adjustments rather than something that will carry forward . In the CC David Kay said this:

Our annual dividend rate, not impacted by these adjustments, and we have laid out in our press release all the other items that are nonimpacted, including net operating income, net asset value, which as an aside, at $1.4 billion, at about 6.25% cap rate is about a $13.25 share price.

What I also was concerned about was if ARCP was still financially sound, i.e. do they still follow their loan covenants and making sure that they are keeping their investment grade rating as it is an important factor for feature borrowing. David Kay had this to say:

We are operating in good faith with the banks, and we'll continue to keep them with the constant flow of information. We have also had initial dialogue with the rating agencies, and there's an open dialogue there as well.

I should hope that they are keeping the banks informed and having open dialogues with banks and credit rating agencies.
Lastly, they still own a large amount of properties with a 6.25% cap rate and the NAV is still 13.25 per share as mentioned above and they are still collecting income from their properties which was one of my primary reasons for holding over the last week.

Plenty of ARCP insider buys have been going on over the year which might suggest that all of them weren't in on it.

Some of these statements are biased since they are coming from the CEO of ARCP so any additional sources in the future will be welcome. With NAV still at high levels David Kay has this to say about buybacks:

I've been asked about share buybacks, and would we sell assets? We do have a share buyback plan in place. I'm continuing evaluating the share price, which we believe is tremendously undervalued. We would look at selling assets, particularly high-valued ones, in order to buyback shares, if the shares continue to stay at these levels.

For me that sounded like a nice way of saying, we have the option but we would rather not. A pitfall with REITS and BDCs are that externelly managed assets carry a management fee which depends on the net value of the portfolio rather than share performance and returns.

If one is more speculative in nature there currently more than 50% potential in the price returning to NAV though I believe that the recent turmoil and earlier actions by management warrant a discount that we probably won't see disappear for a while. Since I'm mostly interested in the dividend this is more of a nice surprise if the price actually reaches NAV.

Are there risks?
Obviously there are still risks, the biggest one being uncertainty at this point and until at least the next quarterly report and probably longer. As mentioned with credit ratings and banks, even without current liabilities being affected much their future growth prospects are low as the cost of capital will  probably rise in the short to mid-term especially when raising capital with equity.

What does the cover up say about corporate culture at ARCP? Was it a mistake or did they do it for their own sake or where they pressured by the culture in the company. This is something that is hard to see when investing and with other questionable management actions that might not have shareholder value as it's primary concern.

I do not believe they will cut dividends next year but it is absolutely a concern that cannot be ignored and remains a risk as long as they continue with their high payout ratio. Guidance for 2015 suggests that the dividend is covered but without the track record to back it up it remains to be seen if ARCP are up for the task. Recently it was announced that the sale of Cole Capital is canceled which was not anticipated by ARCP, they are arguing to get the deal back on the table. At first I thought that keeping Cole Capital would be good but I hadn't thought of the possibility that investors might be more careful to invest with Cole Capital which would mean less income from Cole Capital then I thought. They still make money from Cole though and it's worth more than 0$ as it seems to be worth in the market today. With Cole Capital added into the mix the dividend should have better coverage than before. Though with the capital from Cole they could have bought back shares and lowered debt which would have been preferred at these levels.

Another issue for me is that recent management actions have been questionable. Why by Cole Capital last year only to sell it below par this year with a complex deal? (that benefits RCAP more than ARCP) The multi-tenant portfolio which was also sold for less than originally indicated when it was being spun off. They also issued equity below NAV earlier this summer. Putting all of these factors together one might question management and their priorities.
make money from Cole though and it's worth more than 0$ as it seems to be worth in the market today.

Conlusion
The Dividend Growth Investor states the options very well HERE. I'm of the opinion of holding since besides dividends I do look for Value but I'm not sure if I am comfortable with increasing my position considering the size it already has in my portfolio (5.5%). I also think there are many unpredictable factors which makes me hesitate and if that's the case there are probably better opportunities we're I'm more comfortable. I am still unsure though and I do believe there is a lot of value to be unlocked, I'm just not sure if they have the key.

Full disclosure: Long ARCP, I increased my positions at 9.38$ and might buy more depending on more information coming in and where the price goes next.