Speculating on Iron Mountain's REIT Conversion

Many investors are well aware of record storage operator Iron Mountain's efforts to convert the company from a C-Corp to a REIT.  As a REIT, Iron Mountain (IRM) would be taxed only at the individual shareholder level and would likely reduce their cost of capital, both of which would cause the shares to be re-rated higher inline with storage/industrial REIT peers.  Iron Mountain's primary business is building large storage centers and "leasing" out space on their racking structures to store paper records.  In this business line they have over 67 million square feet of storage space across over 1,000 locations, so there's a good case to be made that Iron Mountain is indeed a real estate driven company.

However, last summer, the IRS initially pushed back on Iron Mountain stating they were "tentatively adverse" to classifying the racking structures as real estate.  The basic question is how permanent are they?  Are the racking structures more similar to walls in a house or removable display shelves in a grocery store?  The market reacted quickly selling off IRM shares from around $40 per share before the announcement.

Iron Mountain hosted an analyst day presentation in March (shares are trading in a similar $27-29 range since) where one of the main topics was the REIT conversion, listen to the whole call if you can, but the key REIT valuation slide is below:

It's fairly clear by these measures that Iron Mountain would be significantly undervalued as a REIT.  If approved, the stock should recapture much of the ground it has lost since the IRS's "tentatively adverse" push-back in the near term, and maybe more upside above $40 over the longer term. 

Management seems fairly confident in a positive outcome, they have been operating the company as a REIT since the beginning of the year in preparation of approval so they could file next year as a REIT.  The board initially announced plans to evaluate REIT status in April 2011 (after some activist pressure), and formally announced the desire to pursue the strategy in June 2012, if plans fail the board and management would face real credibility issues.  Additionally, the IRS recently has been approving non-traditional REITs in sectors such as outdoor advertising, cell phone towers, data storage centers, and casino properties.  There is some time pressure to get approval sooner than later, in order to qualify as a REIT, Iron Mountain would have to make a special dividend within the calendar year to distribute their accumulated earnings and profit (E&P) to investors.  In order to get this done, the company believes they need to initiate the process in October, if the IRS doesn't rule in their favor before, the REIT conversion gets pushed back to 2015.

I'm writing this on Wednesday (4/30) afternoon, earnings come out tomorrow (5/1) morning, if any negative REIT related news is released tomorrow I could end up with egg on my face pretty quickly.  But I couldn't resist a little special situation call option strategy, I bought some call option contracts, nothing big, basically just free rolling the small profit I made on BioFuel Energy earlier this month.

Disclosure: I own IRM calls

Momentum Traders and BioFuel Energy

That was quick!  My last post was on Greenlight Capital's proposed transaction to utilize BioFuel Energy's net operating losses (NOLs) in a reverse merger of sorts with a real estate developer/homebuilder the hedge fund controls (JBGL Capital).  I noted at the bottom that I expected a wild ride because it seems like the current crop of momentum day traders had taken notice to this small float stock with a sexy name and were driving up the price without understanding the Greenlight transaction or reading the details of how BioFuel Energy is going to meet the $275 million price tag for JBGL Capital.

On Thursday, BioFuel's share price jumped almost 30% with no news and well above the maximum range of the rights offering:

5. The Rights Offering. Prior to and contingent upon the closing of the Acquisition, the Company will conduct a rights offering for shares of its Common Stock (the “Rights Offering”) to raise at least $70 million. Each right will permit the holder thereof to purchase shares of Common Stock for a price per share equal to 80% of the average closing price per share of the Common Stock for the 10 trading days immediately following the date of filing of the Registration Statement relating to the Rights Offering (the “Filing Date”); provided, that in no event will the price per share of Common Stock be greater than $5.00 per share, or less than $1.50 per share. Subject to certain limitations, the Rights Offering will be backstopped by certain investors determined by Greenlight.

Based on the initial terms of the rights offering above, anyone buying BioFuel Energy above $6.25 (80% of which is the maximum $5.00 of the rights offering) is guaranteed to face massive dilution after the rights offering is completed.  In order to fund the acquisition, BioFuel is going to have to issue 4-5x as many shares as is currently outstanding, at a maximum price of $5 per share, that's going to force the fair market value considerably lower than where its trading currently.  I don't have the trading mindset to participate in this kind of pump and dump, so I exited this morning at $8.15.  Slightly disappointed that I won't be participating in the rights offering unless things change dramatically, but maybe I'll get an opportunity again once the transaction closes.

Disclosure: No Position

BioFuel Energy's Reverse Takeover

Greenlight Capital and developer James Brickman are proposing that BioFuel Energy (BIOF) purchase JBGL Capital, a residential developer and homebuilder controlled by the two, for $275 million in a reverse takeover transaction to take advantage of the failed ethanol producer's $178.2 million in net operating losses.

BioFuel Energy was founded in 2006 in the middle of the ethanol craze.  The company operated two ethanol plants, one in Nebraska and one in Minnesota, which produced ethanol and related products for the company until this past November when they turned their assets over to the lender in a foreclosure.  After the foreclosure, BioFuel Energy is now a shell company with two assets, $10.8 million in net cash and the aforementioned $178.2 million in NOLs.

At year end 2013, hedge funds Greenlight Capital and Third Point owned 35.4% and 17.4% respectively of the company, one that's a rare investing black eye for each.  The NOLs are clearly valuable, otherwise the company would be liquidated and the $10.8 million would be distributed to shareholders, but the NOLs are only valuable if they can construct a transaction where there isn't a change of control in the mind of the IRS.  In comes the home builder transaction where Greenlight is already the lead investor.  There isn't much available about JBGL Capital on their website, but Greenlight would only choose an asset that would throw off taxable income to utilize the NOLs, so its reasonable to assume its fairly profitable.   I tend to like the residential real estate sector right now and think home builders will have the wind at their back for some time as we're still far below historical new home starts in the US.  The millennials generation will one day move out of their parents basement and start buying homes, just might take longer than most expect due to the financial crisis hangover and student loan debt.

Transaction Details, $275 million for JBGL Capital, compensated by the follow ways:

1. $150 million in debt financing provided by Greenlight, 10% fixed interest rate for a 5 year term with a 1% prepayment penalty during the first two years.
2. A rights offering of at least $70 million, with each holder able to purchase shares at 80% of the 10 day average closing price following the official registration statement.  Maximum price is $5.00, minimum is $1.50.
3. Equity issuance to Greenlight/Brickman, this will ensure that Greenlight owns 49.9% of the shares following the rights offering and James Brickman will own 8.4% of the shares.
4. Cash of $10.8 million currently held by the company

The debt is the most concerning of the above; 10% is awfully high in such a low rate environment, but I view this as Greenlight's preferred return for choosing the asset and being the company sponsor.  But after a few quarters of profitability, you'd assume the company could refinance the loan, but with Greenlight/Brickman being the lenders, would they be conflicted in facilitating a refinancing?

However everything else sets up pretty nicely, post transaction, David Einhorn will become the Chairman of the Board and James Brickman will be the CEO and join the board as well.  So Greenlight will remain the sponsor and presumably a long term shareholder of BioFuel in order to retain the NOLs, any "change of ownership" would disqualify the NOLs in the eyes of the IRS.

At the current price of about $5.30, you get around $2 per share in cash and the market is valuing the NOLs at $3.30 per share or only ~$17 million.  That's a reasonable valuation without any specific details of JBGL Capital which should come with the rights offering and subsequent filings.  BioFuel Energy, probably due to its name, former industry and low float, seems to now be on the radar of unsophisticated momentum traders which could make for a wild ride until the transaction is completed, but I took a very small starter position in the name (with the intention to participate in the rights offering) as I think there could be substantial upside once the dust settles.

Disclosure: I own shares of BIOF