XOMAO - I'm Buying Preferred Stocks Hand Over Fist

2023-12-15 08:30:00 ET

Summary

• Preferred shares present a desirable trifecta of high yields, lower risk, and significant capital upside.
• At these bargain prices, preferred stocks have something for value, income, and growth investors.
• We discuss two +9% yielding preferreds for your passive income needs.

Co-authored with “Hidden Opportunities”

Preferred stocks present an unprecedented opportunity in current market conditions. These financial instruments boast the rare combination of manageable risk, attractive prices, and promising price appreciation, all while offering substantial dividends. Termed "hybrid" securities due to combined characteristics of bonds and equities, preferred stocks represent an equity interest in a company with stable income generation.

Preferred shares are typically issued by companies to raise capital. This loan can be structured in a variety of ways:

• Term preferreds are similar to bonds. They mature at par value and offer a steady yield until then. Term preferreds issued by quality companies are a steal when they trade below par value.
• Perpetual preferreds are, in theory, a perpetual source of income. They can be redeemed if the issuer chooses to do so. Hence, with these, price is what you pay to capture a yield you can collect for the foreseeable future. When interest rates drop, there may be opportunities to sell at a gain.
• Convertible preferreds can be exchanged for common stock based on the stipulated terms. Until then, they serve as a steady income source whose price is often correlated with the prosperity of the issuer.

Most preferred securities carry a liquidation value (normally $25), but since they trade on the stock exchange, the daily price can fluctuate due to a wide range of factors including the security type mentioned above.

Preferred stocks' allure extends beyond stability, offering higher yields compared to common dividend stocks or bonds from the same issuer. These securities also enjoy an advantage in the dividend payment hierarchy, shielding investors from common dividend cuts during financial strain. Let's explore our top picks.

Pick #1: TDS Preferred – Up To 10.4% Yields

Telephone and Data Systems, Inc. ( TDS ) is a Fortune 1000 company that owns 84% of US Cellular ( USM ), the fourth-largest wireless carrier in the United States. USM’s current market cap stands at $3.8 billion in comparison to TDS ’s $2.05 billion, indicating an interesting case of hidden value in need of catalysts to unleash.

For many years, TDS has been under pressure from activist investors to sell USM and do right by its shareholders. Recently, the company announced the initiation of a strategic review to determine strategic alternatives for USM. For Q3 2023, TDS recorded $4 million in expenses associated with this review, and management mentioned that it is active and ongoing, but refused to divulge any specifics. We believe a positive outcome from the review would be hugely beneficial for TDS and USM shareholders, but our interests as income investors lie elsewhere.

Outside its ownership of USM, TDS provides a wide range of broadband, video and voice communications services to residential, commercial, and wholesale customers. Source

During Q3, TDS deployed fiber to 61K service addresses, and raised their FY 2023 goal to 200K, up from 175K. The company continues to be at the phase of higher CapEx for fiber rollout, and while TDS revenues for Q3 remained flat YoY, the company reported a 3% EBITDA growth and a 3% increase in CapEx.

TDS expects to receive $90 million per year starting 2024 until 2038 as part of the federal ACAM (Alternative Connect America Cost Model) program to expand broadband connectivity across the country. TDS expects to receive $1.3 billion in revenue support over the next 15 years to expand its moat across several rural areas.

For FY 2023, the company reiterated its original guidance for revenue and Adj. EBITDA ($270-300 million), but has raised its estimate for CapEx to $550 million (up from its original range of $475 - $525). While these investments provide headwinds to the company’s profitability (in addition to the headwinds from rising interest expenses), it is only a matter of time before they result in increasing free cash flow.

TDS generated $207 million in adj. EBITDA for nine months of FY 2023 while spending $6 million on interest expenses, $114 million on common dividends, and $52 million on preferred dividends. The company ended Q3 with $106 million in cash on its balance sheet ($293 including USM, but TDS does not have direct access to USM’s cash assets). At the midpoint of the Adj. EBITDA guidance ($285 million), we see adequate coverage for debt and shareholder obligations.

• 6.625% Deposit Shares, Series UU Cumulative Redeemable Perpetual Preferred ( TDS.PR.U ) - Yield 10.1%

• 6.00% Deposit Shares, Series VV Cumulative Redeemable Perpetual Preferred ( TDS.PR.V ) - Yield 10.4%

TDS spends very little on preferred dividends and interest expenses, in contrast to its common stock dividend. Notably, the company has raised its dividend for 49 consecutive years, positioning it just months away from joining the exclusive group of Dividend Kings. The company is highly incentivized to keep up this hard-earned trend and this increases the income safety for TDS’s cumulative preferred shareholders.

TDS preferreds pay qualified dividends, and TDS-V presents a large 10.4% yield and offers a massive ~70% upside to par value. A favorable outcome of the strategic review of USM business will lead to a massive upside for TDS preferred shareholders.

The markets are very bearish on TDS common and preferreds amidst projections of higher CapEx in this environment of elevated interest rates. But we can expect the investments to be accretive to FCF generation in future quarters. We saw this with AT&T ( T ) and Verizon ( VZ ), and are happy to hang on to the well-covered and high-yielding preferreds until the big value unlock happens.

Pick #2: XOMA Preferred – Up To 9.4% Yields

XOMA Corporation ( XOMA ) is a biotech royalty aggregator focused on early- to mid-stage clinical assets. The company monetizes and aggregates royalty payment rights associated with pre-commercial drug candidates, and operates with 12 full-time employees, one part-time employee, and utilizes additional experienced executive, accounting, legal, administrative, and other personnel from time to time.

XOMA gets paid when a drug completes each phase of its clinical trials, when an FDA submission is made, and when approvals are obtained. Then when the drug is commercial, XOMA gets a small cut out of every dollar it generates in revenues. At the end of Q3, the company reported a portfolio of 70+ assets, including 2 commercial assets. Source

In recent months, XOMA received two fat paychecks:

• $4.9 million cash payment from Roche representing XOMA’s 0.5% royalty interest related to VABYSMO sales during 1H 2023
• $5 million milestone payment related to the FDA’s acceptance of Day One Biopharmaceuticals’ New Drug Application for tovorafenib as a monotherapy in relapsed or progressive pediatric low-grade glioma

During Q3, XOMA reported a 60% YoY increase in revenues, and ended the quarter with $33.4 million in cash and cash equivalents. Investors must note that the biotech royalty aggregator has no debt on its balance sheet, making its preferred securities the highest on the capital stack.

• 8.625% Series A Cumulative Redeemable Perpetual Preferred Stock ( XOMAP ) - Yield 9.3%

• 8.375% Series B Cumulative Redeemable Perpetual Preferred Stock ( XOMAO ) - Yield 9.4%

The power of royalty income from a blockbuster drug cannot be better explained than the image below. Royalties from a single placement like Vabysmo, at the peak sales phase will adequately cover all of XOMA’s operating expenses and generate substantial free cash flows.

XOMA’s asset base is growing and progressing well, and it is likely only a matter of time before the company starts collecting big royalty checks to achieve bottom-line profitability. Based upon the royalty cash flows XOMA expects to receive from its two commercial drugs in addition to its current cash position, the company expects to continue funding operations for several years, including the payment of preferred dividends, which cost the firm $4 million in the 9 months of FY 2023.

We see attractive income opportunities from XOMA’s discounted preferred securities. Both XOMAO and XOMAP offer comparable qualified yields and price upside, so readers are recommended to set limit orders and buy whichever security presents the best deal at the time of your purchase.

Conclusion

In our Investing Group, we don't just invest; we strategically build wealth through a lifestyle-supporting income stream. Our carefully curated preferred stock portfolio boasts over 45 holdings, delivering an impressive overall 8.6% yield. We aren’t just recommending a 40% allocation to fixed-income, we are also seizing the bargain opportunities with both hands.

Industry expert Cohen & Steers found that preferred securities often have strong performance after rate hikes, outstripping other types of fixed-income products like investment-grade and high-yield bonds. Since 1990, this asset class has achieved an average 12-month return of 12.7% after rate hikes, compared to 10.2% from investment-grade bonds and 9.9% from junk bonds.

"Whenever I see preferreds offering yields in this context, at least by historical standards, they have always done very well" – Bill Scapell, Head of Fixed Income and Preferred Securities, Cohen & Steers

The Fed is almost done with rate hikes and there are strong possibilities of rate cuts in the near term. Now is the time to secure a robust income stream while positioning for significant price appreciation in the months to come. At these discounted prices, we present two picks with yields reaching up to 10.4%, reinforcing your fixed-income allocations before these exceptional opportunities vanish.

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