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In a mature bull market, financial engineering trumps business innovation

Michael Santoli
Michael Santoli
Traders work as a logo for CBS Outdoor is displayed prior to the company's IPO on the floor of the New York Stock Exchange March 28, 2014. Shares of CBS Outdoor Americas Inc rose as much as 9 percent in their trading debut, valuing the outdoor advertising company at about $3.7 billion as it pushes for a bigger slice of the ad market and its parent CBS Corp focuses more on content. REUTERS/Brendan McDermid (UNITED STATES - Tags: BUSINESS ENTERTAINMENT)

We’re getting deep into the financial-engineering phase of this bull market.

Five years of surging corporate profits, fattened stock prices, cheap money and rebuilt executive confidence means company boards and their investment bankers are busy conjuring novel forms of balance-sheet alchemy.

Conditioned by several lean years not to assume strong demand or easy organic growth, companies are keen to defend high profit margins, take advantage of forgiving capital markets and slalom through corporate-finance loopholes to squeeze out incremental value for investors.

[As an aside, this is one reason the small handful of truly industry-transforming, hypergrowth companies in social media and isolated consumer businesses have become so fetishized by investors. They are the select few bold, big-vision businesses out there, and have skyscraping valuations as a result.]

Buy, don't build

The $2 trillion worth of mergers and acquisitions this year are the most straightforward manifestation of this “restless capital syndrome.” That the action has extended to swallow-a-big-competitor-at-a-high-price deals such as Dollar Tree Inc.’s (DLTR) purchase of Family Dollar Stores Inc. (FDO) and Twenty-First Century Fox Inc.’s (FOX) $80 billion offer for Time Warner Inc. (TWX) supports the idea that CEOs are walking the line between boldness and recklessness in a mature market cycle.

Meantime, the Wall Street Journal notes that private-equity firms are swapping more companies among themselves than they're buying on the open market, like baseball general managers at trade deadline looking for pieces valued more highly by rivals (for whatever reason) rather than scouting for new prospects.

The rush for big companies to seek “tax inversion” mergers that move their legal headquarters beyond the reach of U.S. tax levies is the most conspicuous and controversial manifestation of this transactional zeal: Same company, same cash flow, new home office achieved at the expense of millions in advisory fees and immeasurable public-relations points, all to cut tax bills and access overseas cash to fund dividends and stock buybacks.

Redefining real estate

A quieter quest by companies of all sorts to reclassify themselves, or parts of themselves, as real estate businesses in order to capture investors’ lusty rush for yield-producing real estate investment trust stocks is comparably heated.

Private prison operators Corrections Corp. of America (CXW) and Geo Group (GEO) converted to REITs a couple of years ago. Billboard companies CBS Outdoor Corp. (CBSO) and Lamar Advertising Co. (LAMR) recently made the switch. Server farm owner Equinix Corp. (EQIX) and data-storage giant Iron Mountain Co. (IRM) are seeking to do the same.

In every case, the stocks soared to much higher prices and multiples of earnings instantly upon converting, even though the business was unchanged.

REITs are free of corporate income taxes so long as they distribute nearly all profits to shareholders, which gives the stocks relatively high yields collected by investors, who then pay tax on them. To become a REIT, a business must derive most of its revenue from property assets. Traditionally this meant office buildings, apartments, hotels, hospitals and other commercial real estate.

But the current corporate reach for assets to shuffle and cash flows to redirect has even traveled below-ground, to basic phone wires redefined as income-producing real estate by telecom operators. Tuesday’s move by telco firm Windstream Holdings (WIN) to package its copper and fiber network and other real estate into a REIT marked an unforeseen extension of such maneuverings.

Even though the news came with a dividend cut, the shares popped as much as 20% and remain up more than 7% in a sloppy market, stoking excitement among investors that a new trick has been devised and blessed by the IRS.

Oppenheimer analysts noted that, when data-center and cellular-tower stocks became REITs, their shares and price-to-earnings multiples climbed 20% to 40%. Given this trend, “this means that every network stock we cover is roughly 20% undervalued at this point, as they should be able to largely avoid paying taxes going forward." Companies as vast as AT&T Corp. (T) and Comcast Corp. (CMCSA), on paper, can now be seen in this light.

Esteemed value investor and merger-stock maven Mario Gabelli, founder of GAMCO Investors Inc. (GBL), reacted to the Windstream news by tweeting that it’s a “Catalyst for cable TV, utilities, telcos.... Move Over 'Inversions'.”

In other words, installed networks of circuits and wires of every sort could be magically worth more if housed within a REIT.

But this is less about outright tax savings than the enormous, mechanical demand for REIT shares by yield-parched investors in a world of minuscule risk-free interest rates. This, in turn, has ballooned the valuations of REITs to historical extremes.

Expensive bets on low rates

Research firm SNL Financial calculates that the REIT sector now has an average ratio of enterprise value (equity plus debt) to profits of 28-times. That’s a few notches cheaper than the low-30s seen at the height of the real estate and credit bubble in 2006, but is about 50% higher than the valuation of many quality non-REIT companies.

This makes a sort of “valuation arbitrage” irresistible to CEOs and CFOs who suddenly discover they can produce a step-function pop in the trading value of the business by doing little more than filing some paperwork.

The takeaway for investors here is that REITs look richly valued, and arguably are not offering great compensation for the risk. The average yield spread on REITs above Treasury bonds recently traded slightly below their historical average near 1 percentage point.

Stock-research house Leuthold Group says its quantitative models arrive at “a negative view on REITs due to the high valuations and tight correlation to interest rates.” The firm points out that betting in REIts broadly is an outright bet on rates remaining low, not only because they are yield proxies but because REITs constantly have to sell debt and equity to grow, given they pass along the majority of profits to investors.

REITs are a useful structure and good addition to a broad asset allocation. But when the financial engineers can’t help themselves from conjuring new ways to capture soaring valuations in a sector, it should begin to sound an alarm for investors who are too exposed.