ONL - W. P. Carey: When Management Turns Sour

2023-10-03 07:35:00 ET

Summary

• Diversification is crucial in investing, with at least 42 separate securities recommended for a well-rounded portfolio.
• W. P. Carey was once considered a safe and reliable dividend stock, but a strategic change has led to a dividend reset and increased execution risk.
• The decision to sell WPC stock and reinvest in higher-yielding options is based on the need to maintain income goals and mitigate the impact of the dividend cut.

Co-authored with Beyond Saving.

One point I have hammered relentlessly is diversification. We recommend having investments in at least 42 separate securities - an idea that surprisingly receives a lot of pushback. People often say to me that over 40 investments are "too many" and unnecessary. They will declare that they invest in 10 or fewer "high quality" stocks.

The problem is that, as investors, we are always working without the most vital piece of information for any investment - we are always making decisions without knowing what will happen in the future.

Investors imagine they can predict the future - you can't. Investors often ask me what security in the our portfolio is the "safest," which are the least likely to cut their dividends, or which are "the best." Unless you've been to the future, you can't know.

W. P. Carey Inc. ( WPC ) is a dividend stock that I thought was a buy-and-hold "forever" investment. Among the picks I discuss publicly, WPC is one where I get very few comments declaring it is too risky. It has consistently raised its dividend for over 25 years and adopted a policy of raising its dividend every single quarter. It has done so through two recessions and COVID. In our model portfolio, it has been one of the lower-yielding options.

If you asked me two weeks ago which stocks were the "safest" in terms of dividend safety, WPC would have easily been near the top of the list. And among the holdings we cover, it is one of those that most others would also have agreed had a very secure dividend.

You can't predict the future.

WPC recently announced a strategic change that will result in a "reset" of the dividend. While this strategy could bear fruit in the future, and in the long run, it could lead to a higher valuation and higher total return for shareholders, it introduces a lot of execution risk; worse, the reduction in the dividend will put WPC's yield much lower than we need to suit our income-based strategy.

Therefore, we issued a sell alert on WPC. Fortunately, most other options in our portfolio have a higher yield, so redeploying into other HDO holdings will result in an increase in income.

The Strategy

WPC is spinning off its office assets like Realty Income ( O ) did with Orion Office REIT ( ONL ). Shareholders who continue to hold will receive shares in the new company. However, unlike ONL which is paying a dividend and is expecting to expand its portfolio as a standalone company, Net Lease Office Properties ((NLOP)) intends to sell off the assets. The proceeds will be used to repay debt, and then anything leftover will be distributed to shareholders in lump sums.

WPC will continue to operate with a much smaller portfolio of office properties. Something that management believes will allow the shares to trade at a higher funds from operations, or FFO, multiple. Additionally, WPC is using it as an opportunity to "reset" the dividend, with the intention of paying out 70-75% of AFFO. Currently, they pay out over 80% of AFFO. So shareholders will see the dividend reduced due to the lower AFFO caused by spinning off cash-flow positive properties, and they will also see it reduced further as a choice to operate with a lower payout ratio. Our initial assumption was that WPC would cut 10-15% to reflect the loss of the office properties, after reviewing the numbers, we now believe the cut will be well over 20%.

Retaining more cash will provide WPC with cheaper capital to be even more aggressive with its acquisitions. WPC management believes that the market will ultimately reward WPC with a higher valuation with a portfolio clear of the out-of-favor office sector and faster growth. It is likely that after the cut, they will resume dividend growth. If the plan works as they expect, they could maintain a faster pace of dividend growth than they have seen in recent years.

What perplexes us is that WPC has already reduced its office portfolio by 35%. It could have continued to sell off the properties gradually without putting the dividend at risk. Sure, growth might have been a bit slower, but WPC, like all REITs, relies heavily on issuing common equity to fund growth. I believe management is dramatically underestimating the long-term impact of a dividend cut on their valuation, which will reduce their ability to issue shares at attractive prices. A company with a 25+ year dividend streak is special, and it was something that made WPC very special in the eyes of many shareholders. If I am okay with a REIT that has a history of dividend cuts, there are many higher-yielding options.

To Hold or To Sell

The benefit of holding WPC is that you would receive shares in NLOP. You would receive dividends as NLOP sells properties, likely over the next 1-2 years. It is possible that these dividends are higher than the spinoff price, but it is also possible they are lower. NLOP will be paying management expenses and will have debt to repay first. The new company will be taking on debt to replace the leverage that WPC used, and as a smaller company it will pay a much higher interest expense than WPC was paying. The longer it takes to liquidate, the less shareholders will ultimately receive as their potential recovery is eaten into by interest and management expenses.

WPC should be able to increase its dividend more aggressively, making it more appealing to dividend-growth-style investors. However, it could take a long time to shake off negative sentiment from the dividend cut. For those intending on holding for 10+ years, the end result could be very positive.

We don't think that management is entirely wrong, the idea that the strategy will create long-term value is reasonable. Those who are willing to forgo the near-term income and hold for the long term will likely be very happy with the results in the future.

For us, WPC was already a borderline holding in terms of the yield it offered. With the cut, it is simply too low for us to achieve our goals. After the spin-off, it might be worth considering either WPC or NLOP, depending on the price and the outlook for dividends.

Conclusion

This is an important reminder of the importance of diversifying and not piling everything into a handful of companies you consider to be "the best" or "the safest." It is also a reminder that a lower yield does not necessarily mean the dividend is safe.

WPC was easily covering its dividend with a payout ratio consistent with its historical average, it hiked its dividend consistently for decades, even last quarter, and its business has been growing by every measure. Yet management decided to make a strategic shift, and the result of that shift threatened the dividend.

WPC is the type of dividend stock we thought we would "hold forever," but with this change, WPC no longer fits our goals. Fortunately, if you are following the Income Method, WPC represents just one of at least 42 income streams, and since it had a lower-than-average yield, that income is easily replaced in a market where a lot of yield investments are trading at a low price. The damage to income investors is much more psychological than it is financial.

WPC's management made a horrible decision, WPC management is destroying value that will take years to rebuild, but our income is going up anyway. We sold WPC and are reinvesting in other high dividend opportunities.

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