ROIC Reduces Warrant Overhang, Boosts Huge Potential Stock Gains

This morning, little-known West Coast shopping center REIT Retail Opportunity Investments (ROIC 1.57%) ("ROIC") announced what investors have been waiting for: substantial action on the outstanding warrants to buy shares of stock at $12.

When ROIC formed as a special purpose acquisition corporation (SPAC) with an IPO 2007, the SPAC practice was to issue stock, warrants, and units -- a combination of stock and warrants. At the IPO and later when ROIC announced its move to a REIT model in late 2009, it had issued 49.4 million warrants, including8 million to the SPAC founders. At the end of 2012, only 1,000 warrants had been exercised for cash.

Today, the company announced that 57.3% of the warrants have been exercised for cash by investors for $12 a share or $162 million and on a cashless basis by the SPAC founders. From 1,000 to this is, ahem, news. Exercise of the remaining would bring in about $253 million. However, the company purchased 7.8 of the warrants themselves at $1.38, an 18% premium to yesterday's $1.17 close and implying a $13.38 stock price.

Expiring 18 months away on Oct. 23, 2014, the warrants offer both potential shareholder dilution -- included in diluted EPS calculations already -- and cash for investment. However, if management invests the cash for higher returns, the dilution could be a wash -- what every executive in similar situations promises will be "accretive" but rarely is. Meanwhile, despite a steady stock rise, uncertainty over the warrant status has most likely -- and management agrees -- prevented even more gains from yesterday's $13.18 a share close.

Potential near-term gains
A possible $18 and up could well come with the warrant overhang removed based on comparables. While there are roughly 25 REITs loosely in the strip mall, shopping center and mall spaces, Regency Centers (REG 1.06%), Acadia Realty Trust (AKR 1.79%), Kimco Properties (KIM 2.59%), and ROIC are most similar because they specialize in grocery-anchored centers.

Sources: S&P Capital IQ and my calculations. *AFFO is adjusted funds from operations, which is the equivalent of operating cash flow minus maintenance capital expenditures, and is considered the amount available for the REIT to payout.

The case for an increased ROIC valuation has three parts. First, though its market cap-to-LTM AFFO multiple is less than all but one, and seems not exactly low, ROIC offers the highest yield by far, and all else equal should sell for more. This supports the case that "something is holding it back," in which the "something" is likely the warrant overhang.

While the debt to asset percentages are at or near the 50% we'd like ROIC not to top, and Acadia has room to grow, the clear winner for margin of safety is ROIC, selling at a whopping 85% tangible book at a percentage of share price. This indicates far higher asset protection than any of the others.

ROIC is what you buy if you want hard asset based downside protection so paying peanuts for the upside. Who doesn't? These are very good reward-to-risk odds.

Caution warranted
There are also three uncertainties regarding the warrants. So long as the stock remains above the $12 strike price, investors are more likely to exercise them, the company receive money, and shareholder count increase. But if the stock were to decline below $12 and remain there at expiration, outstanding warrants would expire worthless and without exercise -- no dilution, but also no cash from exercise. And for all sorts of reasons beyond my pay grade, the company is able to and could change the warrant strike. For all these reasons, reducing uncertainty over the warrants is good for the stock and for shareholders. 

Potential multi-bagger
Whatever the outcome, investors must be patient for any stock rise after the warrant uncertainty is removed and assuming continued positive fundamentals. In the short term, we must ignore at last one expected bump in the road. The company expects to announce in its May 2 first-quarter report a guidance revision downward because of the timing of receiving the capital and investing it.

ROIC's quarterly dividend has risen steadily from $0.06 a share at inception to the most recent quarter's $0.15. The latter is a run-rate $0.60 annually and 4.6% yield on yesterday's $13.18 close. With the company's investments, low leverage, and a disciplined CEO intent on paying value prices for strong unique assets on the West Coast, now is a great time to invest with patience. First, patience for now to warrant expiration, and then a potential long-term catalyst, where multi-year patience could yield multi-bagger gains. CEO Tanz created in 1997 a similar REIT, Pan Pacific Properties, selling in a hot real estate market to Kimco in 2006 for 9 times its original value.

Meanwhile, CEO Tanz's history of purchasing shopping centers in strategic locations at discounts from distressed buyers provides a margin of safety. And at today's valuation, investors take little risk for multiple future opportunities for gains. Value investors are licking their lips.

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